Chinese regulators are mulling an application by Shenzhen-based China Southern (Nanfang) Fund Management to launch the nation's first principal-guaranteed mutual fund.

The drivers behind a guaranteed fund are similar to those in Hong Kong, where guaranteed funds have been virtually the only capital market investments retail investors have been willing to buy, in order to beat bank interest rates on deposits without assuming the risk of the volatile equities market.

But there is one huge difference: China lacks a market for derivatives. In Hong Kong and other markets that allow principal guaranteed funds, the bulk of an investor's money goes to zero-coupon bonds, while a smaller amount goes to highly leveraged options on the underlying equities in order to make enough of a return to cover the guarantee; and a proportion will also cover fees.

That structure will be impossible in China, at least until it develops a futures and options market. So the proposed guaranteed fund would invest partly in bonds, and the rest in equities, say China Southern officials. It would also guarantee investors 100% of their principal after three years, plus the usual upside should the fund make money; early redemptions would be allowed at the fund's net asset value.

Guarantee aside, then, the fund would operate like any other mutual fund. Even so-called equities funds in China must have at least 20% in fixed income; last year saw the first fixed-income funds but many of these put at least a small allocation toward equities. Everything is a version of a balanced fund. China Southern executives wouldn't comment on their proposed equity allocations for a guaranteed product, noting it would fluctuate based on market conditions anyway.

Also complicating this structure is the question of a guarantor. In Hong Kong, for example, the fund manager will typically get a highly rated bank to guarantee the principal, in case their management of the option doesn't pan out. Chinese fund managers proposing guaranteed funds would like a domestic bank to do the same, but it is not clear under Chinese law whether this will be permitted; nor is it clear how confident banks will be in local fund managers' abilities to return 100% of the capital in three years.

Other fund managers in Shenzhen argue that the guaranteed funds now presented to the China Securities Regulatory Commission are not in investors' best interests. Investors would be better off with a simple bond fund if they just want to get 100% of their capital back, they say. Critics also note that in Hong Kong, guaranteed funds will promise not just the original principal, but enough to pip what savers would get from a bank deposit in the same period of time.

And while the proposed guaranteed-fund management fees of 1.20% are lower than a typical equity fund fee of 1.50%, they are higher than a bond fund's fee of 0.75%.

Nonetheless, officials at China Southern believe a guaranteed fund would be well received, and ultimately it would return people's money even in poor markets. The idea emerged last year when the firm marketed its first fixed-income fund, and found that novice investors often shied away because they couldn't understand the differences of risk. A fund promising their money back should markets do poorly, however, was seen as likely to gain investors' trust.