Investments with a solid structure

Low risk or high returns? Ceri Jones looks at a product that claims to offer both.

At the heart of all our investment decisions, there is always a dilemma. We want the high potential returns only shares can offer, but without having to take any risks. This means that there will always be a thriving market for any financial product that claims to offer the best of both worlds - high stockmarket returns and capital protection.

Capital guaranteed

The latest incarnation of this type of investment is 'capital guaranteed products' - a variation on a wider group of plans known as structured products. They are linked to an index and offer to match either all or some of its growth, and your money back if it falls.

They work by investing around 90% of the fund in cash, zero coupon bonds (bonds that don't pay any interest but are guaranteed to redeem at a particular value at a particular point in time) or the money markets. This part of the investment provides your guarantee.

The other 10% is invested in complex market tools called derivatives, which effectively multiply your exposure to the underlying market (known as gearing).

Capital guaranteed plans are actually a variation on the notorious precipice bonds (or stockmarket-linked bonds) that bombed so spectacularly in recent years. The difference is that those products had no cap on downside risk, while today many plans offer a full money-back guarantee.

However, before buying into capital guaranteed products, you need to consider the variables. One is the term of the product - usually between three and seven years. You need to be happy to tie your money up for the term, because pulling out early can be costly.

You also need to think about what you may be foregoing by tying up your capital over the longer term. While you may be guaranteed your money back if all else fails, you won't earn any interest such as in a high interest savings account.

The weakest link?

Another important consideration is the index a structured product links to. Though most are linked to the FTSE 100, there are countless options - everything from those linked to a basket of the world's biggest companies to property prices.

Many advisers recommend linking only to a large index rather than a basket of shares, because in a smaller basket, the worst performer is likely to determine your return. The FTSE 100 is the least risky because the UK market is largely defensive, with heavy weightings in financials and oil.

Experts also recommend avoiding volatile markets such as the Nasdaq. However, if you particularly like a market, a guaranteed product may be a simple way to gain exposure.

A watertight guarantee?

You must also consider how your guarantee and potential growth are structured. Some plans offer more potential growth if the index rises, but no guaranteed minimum growth.

Consider the strength of the guarantee. With the exception of NS&I products, which are backed by the Treasury, most investors buy from companies that are effectively marketeers who in turn pass the money to the specialist arms of a few big banks. For example, GE Life, NDF, Scottish Amicable and Scottish Mutual all hand funds over to Abbey National Treasury Services.

You also need to decide whether you want growth or income. At the moment, the vast majority of products are set up to offer growth, and the income products still put your capital at risk, so are to a certain extent more like precipice bonds.

Finally, think about tax status. Different types of capital guaranteed products are subject to different kinds of tax. Some products, for example, are held within a life insurance wrapper, so gains are subject to income tax. Others are registered in Dublin and are structured as shares, so capital gains tax (CGT) is payable on the gain. Some of these are ISA-able, however, so you can be sheltered from the CGT.

If onshore products have a guaranteed return based on deposits (such as NS&I), growth is usually subject to income tax. Some providers get around this by investing in the money markets rather than deposits for the cash part of the investment.

The other options

There is great debate over whether any kind of structured product can be better than a diversified portfolio containing cash, bonds and equities.

Patrick Connolly, research and investment manager at IFA John Scott & Partners, says the NS&I Guaranteed Equity Bond Issue Number 8, which offered full capital protection and a minimum return of 15% or 75% of any rise in the FTSE 100, was worth only 2.9% a year before tax. "You could argue someone so cautious should be invested in cash," says Connolly.

But there's plenty of evidence that people want an all-in-one solution that offers the best of both worlds. NS&I's Issue 7 sold over £500 million, with several single investments of £1 million-plus. A spokesperson says: "We're still reaping the benefits of investors who are too nervous to go back into the stockmarket."

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