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Patience is a virtue

Fallen segregated funds hold promise

Segregated ("seg") funds are investment funds sponsored by life insurers. They differ from mutual funds mainly in their provision of capital guarantees on maturity and upon death. While the fees on many seg funds are simply prohibitive, the capital guarantees may provide a good opportunity for seg fund investors who have experienced steep losses over the past couple of years.

Seg fund guarantees

A seg fund, which is technically a variable annuity contract, provides both maturity and death guarantees. The maturity guarantee works like this: An investor (a.k.a. policyholder) will receive, at maturity (i.e. on the policy 's ten year anniversary), the greater of the market value of the policy and three-quarters of the net deposits into the policy. A few years ago, it was standard practice for insurers to offer a full 100 per cent maturity guarantee, rather than the 75 per cent mandated guarantee. Today, both options are available with the higher guarantee carrying higher fees.

The death guarantee works similarly, except that the timing isn't based on a set period, but rather upon death. Again, the policyholder is guaranteed to receive either the market value of the policy or 75 per cent of the net deposits - whichever is greater.

While payments with regard to both guarantees are taxable as capital gains, the death "top up" payment isn't likely to attract any tax bill since a capital loss equal to the top up is usually available upon death as an offset.

Also, as you can tell by my wording, each of these guarantees is based on each "policy". But just like any investment account, most investors hold more than one fund inside of each seg fund policy. In other words, diversifying by holding more than one fund within one policy reduces the likelihood of ever needing the guarantee (and results in overpaying for the benefits).

Finally, making an outright withdrawal from a policy may affect the guarantee. For example, a policyholder invested $10,000 and watches the market value fall to $5,000. If this policyholder withdraws $1,000, her guarantee will fall by 20 per cent. In other words, some insurers will not stick strictly to the net amount invested (which would be $9,000 in our example) but rather reduce the guarantee proportionately based on outright withdrawals as a percentage of market value at the time of each withdrawal.

Technology seg funds

We know that technology investment funds sold like made back in 1999 and 2000 - and seg funds were no exception. I propose that those seg fund investors who have been most severely burned by the bursting of the tech bubble may be sitting on the best returning investment they can find over the next several years.

Only five seg funds emphasizing technology stocks have existed for a full three years, as of the end of July. The median loss by these funds was negative 26.4 per cent per year. Put another way, the median technology seg fund has shed more than 60 per cent of its value over the past three years.

The opportunity

What I see as an opportunity is really for those investors who held seg funds through the tech stock debacle until today. An investor who purchased a technology seg fund three years ago would have probably bought into a fund offering 100 per cent maturity guarantees. Using the figures from the median technology seg fund, an investor would realize a rate of return of 14 per cent annually simply by hanging onto the battered fund and simply getting original capital back.

Sure, overall all such an investor would get back would be their original investment in my example. However, the money is already lost, so the focus has to be on a forward-looking basis.

An investor who invested $5 in a technology seg fund three years ago would be left with $2 today; but may be guaranteed to receive $5 in seven years. Turning $2 into $5 over a seven-year period is equal to earning a rate of return of about 14 per cent per year. And that's guaranteed. Even if only 75 per cent of the original capital is guaranteed at maturity, that's still equivalent to a return of nearly 9.5 per cent per year over the next seven years.

That's a tough deal to beat on a forward-looking basis.


Before you cringe at the thought of hanging onto your battered technology fund for another seven years, try to forget the awful experience you've had over the past couple of years. I won't deny that returns for tech stocks have been downright ugly over that time; but the focus should be on what lies ahead.

I'm not endorsing the purchase of seg funds for the capital guarantee feature. Rather, for technology seg fund investors who are already sitting on big paper losses, the potential for a very attractive rate of return lies ahead in years to come. In planning your portfolio decisions, this is something to keep in mind.

Dan Hallett, CFA, CFP is the President of Dan Hallett and Associates Inc., an independent investment research firm based in Windsor, Ontario. Dan can be reached at


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