So you want to buy stocks but don’t like losses, right? Well have we got the thing for you: a principal-protected fund. If stocks go up, you make money. If stocks go down, you get your money back.

If this sounds too good to be true then you’re half right.

Principal-protected funds do indeed exist. They provide market exposure with a chance to participate on the upside while setting a minimum of downside risk.

The strategy is sound but it’s not new. Indeed, it strikes us that the proliferation of principal-protected funds smacks of the same marketing zeal that has made household terms of hedge funds, currency ETFs, commodity plays, long-short strategies, emerging markets, M&A arbitrage and, well, you get the idea.

We’re not bashing these principal-protected funds. We like the idea and think it makes sense in some circumstances. But we believe different/better alternatives are out there if you know where to look.

Let’s take a look at how principal-protected funds work…

The funds are predominantly the purview of large, well-established and well-capitalized insurance companies. They invest your money in a basket stocks with the promise that, if prices go down, the initial investment is guaranteed to be returned after a minimum holding period – typically 5 years.

The upside is stock market gains. The downside?…the opportunity cost of what could have been done with the money over the 5 year period had it not been locked into a zero-growth investment (which is what the return of principal amounts to in the situation where stock prices have declined). That sounds pretty compelling.

So what’s the problem? Well, the basic flaw is in how the money is invested. Because of the principal guarantee, the management companies have a strong incentive to protect themselves from paying out of their own pockets. The result is a portfolio positioned so conservatively that the upside is being sacrificed.

It can’t be that bad, can it? I’m buying a bunch of stocks, right?

Consider that the average return is about 3.3% annualized over the trailing 3 years which lags the S&P 500 by almost 11% and barely beats the return on the Lehman Brothers Aggregate Bond Index by 0.70%.

To make things worse, the average expense ratio of principal protected funds is 2.06%…ouch! You get principal protection but you also get mediocre performance and high fees. All of a sudden this doesn’t sound like a good idea.

It should be noted, however, that Merrill Lynch Basic Value Principal Protection has outshined the competition by delivering decent returns.

It’s up an annualized 9.6% over the trailing 3 years with an expense ration under 1% (although we could do without the 5.25% front-end load on the “A” shares and the 0.25% 12b-1 fee).

To add insult to injury, the management of these funds seems to have given a no confidence vote. According to SEC filings, it doesn’t appear there’s a single principal-protected fund in which the managers have invested any of their own money. Not to pick on any one firm but ING offers a whopping 12 principal-protection funds and its managers (as well as fund directors) have a combined $0 of their own money invested. Is this a “do as I say and not as I do” approach to investing?

OK, so how do I use the principal-protection concept and get decent performance with low fees? Well, we offer two options in the current market environment.

Short-term investors who cannot deal with principal risk should look into high-yielding money market funds or CDs maturing in 0 – 2 years.

Thanks to Ben Bernanke, cash yields are the highest they’ve been in several years. Many online banks are offering rates over 5% (such as OneUnited Bank based in Los Angeles which is currently paying 5.15% on savings accounts). The average 6 and 12 month CDs are currently yielding 4.61% and 5.06% respectively.

Long-term investors might consider a “hybrid bond strategy” comprised of high-yielding, dividend-paying stocks. We like the pharmaceutical sector as it’s seemingly the only one that’s both defensive and growth-oriented at the same time. OK, but what about principal risk? We make no guarantees but find it difficult to envision a scenario where a portfolio comprised of stocks such as Pfizer (4.2% yield), Bristol Myers (4.5% yield), Merck (4.1% yield) wouldn’t be worth as much if not more in 5-10 years than what you’d pay today.

Plus you get to collect fat dividend checks along the way.