Your Funds: No-loss guarantee is nice, but there is no free lunch

Promising the avoidance of loss, guaranteeing the return of principal or a certain level of payout — those are things that consumers have been going for of late, in everything from principal-protected funds to absolute-return funds to managed-payout issues.

But an obscure settlement between a fund company and the Securities and Exchange Commission shows just how hard it is for everyone involved in these kinds of funds to have a clear understanding of how they work and what they cost. The shocking case hasn't garnered much mainstream press, but the fund world has taken notice; ultimately, it may put the kibosh on some new fund ideas currently in the pipeline.

If you want to see the cost investors can pay in exchange for certainty, put on your hip waders and plow into the muck left behind by the MainStay Equity Index fund (MCSEX), which was sold with a guarantee protecting shareholders against principal loss. The guarantee promised shareholders who stuck with the fund for 10 years that they would never get back less than their initial investment amount. If the original investment, plus reinvested dividends, was in the red after a decade, the fund would make up any difference.

For nervous investors, it's a comforting idea: Trade some of the market's possible upside for protection against a loss. MainStay's funds are run by New York Life Investment Management; as a subsidiary of an insurance company, it's no big surprise that the firm was trying something different, taking guarantee features normally associated with an annuity product and putting them into a fund.

That said, insurance products can be pricey and hard to completely understand. That doesn't change when those features are added to funds.

According to the settlement agreed to in late May, from early 2002 through mid-2004, the fund board of trustees approved three management contracts that allowed MainStay to collect some of the highest fees in the peer group for an equity-index fund.

At the same time, filings that management made with regulators said there was "no charge" to the fund or its shareholders to pay for the guarantee.

But there are no free lunches in the financial world, and management was lumping the guarantee costs in with the rest of the fund's expenses.

For the years when the market was booming, the guarantee wasn't actually necessary. Once market conditions changed and the 1990s bull market ended, however, the conditions of the no-loss promise changed, too. The fund established a reserve, and actually stopped taking new investments at the end of 2001, so that it did not extend the no-loss promise once market conditions turned ugly. The fund has never reopened to new shareholders.

At the time, an independent consultant told the board that the fund's management fees and total fees were both the highest in its peer group, which was why the fund ranked worst among its index-fund peers. Moreover, the consultant said the guarantee was "of somewhat limited value" and questioned why there seemed to be no costs associated with it.

In time, it became clear that the fund company was pocketing a much bigger profit margin on this fund thanks to the guarantee costs. By not breaking those expenses out separately — which would have avoided the confusion — the firm misled its own board and shareholders; in the settlement, New York Life agreed to pay $6.1 million in restitution and penalties.

It's equally important to note that the fund did for shareholders exactly what it promised to do: provide them with a no-loss guarantee on the Standard & Poor's 500. The insurance never lapsed; through last October, MainStay had paid out nearly $9 million to shareholders taking advantage of the guarantee.

Still, with products carrying implicit or explicit guarantees being a hot topic in fund shops, it's clear that consumers may have a hard time figuring out how "the next big thing" works, even if it avoids MainStay's issues by making proper disclosures.