Protection money

Capital protected products sound like the solution to today\'s volatile markets, but advisers remain sceptical as to their true value says Sonia Speedy

With global markets in turmoil, nervous investors are increasingly looking to capital protected funds as a safe haven. But many advisers remain unconvinced the products provide the answer to investor concerns.

Capital protected funds can include guaranteed equity bonds, structured products, protected unit trusts and protected investment companies. According to the Investment Management Association definition, protected and guaranteed funds are those funds, other than from the money markets, which aim to provide a return of a set amount of capital back to the investor. This is either explicitly guaranteed, or provided using an investment strategy that is highly likely to achieve this objective, along with some market upside.

Anne Young, senior technical manager at Scottish Widows says protected funds are currently one of Widows’ and Lloyds TSB’s most popular fund offerings. “With turbulent times in the market people get very, very nervous about going into stocks and shares,” she says.

“So things like protected funds are very popular at this time, when you get people wanting to get the upside of the market, but with a safety net that things are not going to go completely belly up.”

Elliot Fowles, head of structured products at HSBC Investments also says the size of investment from advisers into alternative strategies, such as protected products, is on the increase – both for core and satellite investments. “Alternative investment strategies are where structured products fit in. It aids diversification and complements long-only investments,” he says.

Roland Kitson, sales and marketing director at Close Investments argues that protected funds are applicable for investors at any time, but agrees that current market conditions make them particularly relevant.

The proponents of such products promote the diversification benefits of protected funds, the ability to gain exposure to asset classes that may otherwise be difficult to access, and liquidity, as well as the peace of mind they provide for investors. For most investors the top investment priorities are capital protection or low risk, followed by liquidity says Kitson.

“People want to be able to get at their money when they want to get at it. They don’t know when liabilities are going to become due. They don’t know when the roof is going to blow off the house or the house is going to get flooded and they’re going to need an injection of cash,” he says.

Kitson believes protected funds help to meet this desire for a product that offers some of the security of cash, but with some exposure to the equity risk premium.

“It’s trying to find something that provides you with that sort of security and instant access, and by doing that removes the timing risk from equity investment. I think protected funds provide a very good way of doing that.”

He sees protected funds as applicable not just for “widows and orphans” but for those taking their first steps out of deposit accounts, for cautious investors and as an alternative to with-profits funds.

“I think they’re also a core holding for any investor around which they can build more specialised and perhaps more adventurous exposure to other areas – because they can do that in the knowledge that the base of that portfolio is solid and secure in a protected fund” he says.

In April HSBC launched its latest tax-efficient capital protected plan and capital protected Isa, offering 106 per cent participation in any growth of the FTSE 100 at the end of the six-year investment period. There is no annual management charge, but an initial charge of seven per cent for the full capital protected period is incurred. Gains realised from the plan are taxed as capital gains.

HSBC’s Fowles says around half of the structured products available in the UK are based on the FTSE 100, but there are many others that offer exposure to non-UK markets with the safety net of up to 100 per cent capital protection.

“We’re seeing more and more innovation within structured products, so a client may want to diversify their portfolio away from the UK. Structured products give them a way of actually getting exposure to commodities, fund of hedge funds, foreign exchange, global emerging markets, water and green energy,” he says.

But many advisers are less convinced of the relative merits of capital protected products.

As Bob Perkins, technical manager at Origen highlights, investors in protected funds miss out on the dividend income they would have received had they invested directly into the share market. “Part of the cost of entering that type of product is you give up the income – the income actually helps to fund the so-called guarantee,” he says.

Additionally, in order to get the maximum benefit from the protection in place, investors generally need to stay in the product for the full investment term, although some do offer an exit option at specific points.

“I don’t like them, because you’re paying for a guarantee somewhere,” says Nicholas O’Shea, business development director of Pharon IFA.

“Anybody invested within an equity-based fund should expect volatility. They’re going to go up, they’re going to go down – that’s what equities do. Therefore they should be investing for a period of at least three-to-five years in our opinion,” he says.

“Over that three or five year window, generally everybody’s going to at least break even – so why do you need a protected product? When you should be making good money, you’re actually losing it within protected funds because you’re paying for the guarantee somewhere.”

He also describes them as expensive, suggesting they generally add an extra 0.75 per cent to the annual management charge of the typical managed fund.

Keith Churchouse, director of Churchouse Financial Planning offers similar thoughts. “If people are that concerned about investing in the market, then why bother in the first place?” he queries.

He also believes that some of the current interest around capital protected products may stem from investment companies looking to stem net investment outflows to keep some of the money in-house. But product providers firmly believe protected funds have a strong place in the market.

Kitson says: “The detractors will always say that in a bull market you give up some of the upside and it’s true that you do. But none of us call those bull markets right anyway – none of us know when they’re coming to an end.

“The point really is that you want to be able to benefit from those rises when they occur, and miss out on the downs when they occur in the knowledge that the process is put in place for you, you don’t have to make decisions as to the right time to remove your exposure,” he says.

“We know that most private investors buy at the top of the market and sell at the bottom. It was ever thus and it takes the market to recover substantially before they generate sufficient confidence to go back in again. In a protected fund you don’t have to generate that confidence, because you’re covered either way.”

Perkins says that despite the capital protection in place, such products are not risk-free.

“One significant risk is that many of them use counterparty guarantees and usually these counterparties are large banks,” he says.

“The ‘guarantees’ are only as good as the people who are underwriting them. And if you don’t know the people who are underwriting them, or you don’t understand the basis on which the so-called guarantee is made, then that’s a significant risk,” he says.

These days it is largely only cash products that are referred to as “guaranteed” while “protected” is generally the preferred term for these products.

Young says that the level of protection sitting behind protected funds is generally robust, but she agrees care needs to be taken to check out just who the funds are invested with.

“Providers don’t say it’s guaranteed – because at the end of the day any company could go belly up. But I would be fairly confident about any of the major companies that are offering these protected products,” she says.

You can be confident of not losing money with capital protected products, but how much you will make is another matter.

Protection selection – which capital protected products?

Sally Collins, senior investment adviser at Bestinvest says the firm has historically taken a cautious approach towards capital protected products, due to the potential inflexibility they can contain.

“There are a select few that we do recommend in certain circumstances, particularly as part of our discretionary fund management service,” she says.

Collins believes protected funds can offer cautious investors some comfort, while also offering exposure to asset classes that might not be readily accessible to the typical retail investor elsewhere. However, the fact that exposure to the upside may be capped, and that exit penalties can be included, means that Bestinvest treads with care when recommending them.

“When we do recommend them they tend to be into more volatile sectors or those that it is harder to gain exposure to. For example we have recommended the Dawnay Day Quantum Protected Commodities Accelerator fund which invests into hard commodities. That gives you a bit of downside protection but also exposure to an asset class that can be difficult to gain access to,” Collins says.

It also recommends the Merrill Lynch Japan Accelerated Growth Shares fund, which again offers access to a volatile sector, but with limited downside risk.

Collins points out that five to 10 years ago, when the word “guarantee” was more freely used in the financial services market, many products would contain small print stating that capital was protected, but only if the market did not drop below a certain level – in which case investors could end up with geared losses. “There are a lot less of those in the market now because regulation is a lot more stringent,” she says.