The funds guaranteed to disappoint

published 29 August 2007

There's nothing marketing people like more than vulnerability. And with the stockmarket in freefall last week, there is plenty of it about. Nervous investors are bailing out of equities and looking for safer places to put their money. That's when the sales people behind capital-protected funds start rubbing their hands together. Similar in scope to guaranteed equity bonds (Gebs), the idea behind these funds is that while you still get exposure to rising markets, your initial capital will be protected against any falls. And although not legally bound, as Gebs are, to return the guaranteed amount of capital, they are more flexible, in that you can buy and sell units whenever you want.

Some advisers like the look of them. "For people who want returns that are more attractive than cash, but do not want to see their money disappear down the drain, Gebs and protected funds offer a good alternative to stockmarket funds," says James Davies of discount brokers Chartwell in The Daily Telegraph. However, as Myra Butterworth, also in the Telegraph, points out, "financial protection certainly comes at a price". Had you invested £1,000 in the average protected fund five years ago, it would now be worth just £1,321, against £1,796 for the average UK unit trust. And other independent financial advisers are less keen on the idea. According to Mark Dampier of Hargreaves Lansdown, "the vast majority of protected products are poor value, expensive and over-marketed especially at times of volatile stockmarket conditions".

That's because the funds put the capital protected amount, a figure that can vary from anything between 80% and 100%, in relatively safe assets, such as high-grade bonds. The rest goes in riskier ones, like equities. But because of the insurance in place to guard against any falls, your returns are limited even when the market is rising, making it a very bad long-term investment. And they could end up losing money. Take the Close UK Escalator 95 fund, which has returned 42.5% over the last five years. You risk losing up to 5% of your capital along with any gains every three months, if the FTSE 100 falls by 5% or more over that period. So in the "unlikely event" that the market fell by more than 5% every quarter for a year, a £1,000 investment would have become £700 after fees, says Butterworth. In reality, if you are so concerned about the market, that you are looking at this type of product, you'd be better off putting your money in cash for now. And if you want to be in the market, rather than protected funds, choose "quality fund managers", says Dampier. He likes Neil Woodford at Investec and Robin Geffen at Neptune.