Are you playing it a touch too safe?

Protected funds may look attractive in a period of stock market volatility but they could cost you money in the end, says Melanie Bien
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The Independent Online

Whenever volatility of the kind we have seen in recent months affects the stock market, most of us become wary of investing in shares. But the only other option for our money is a savings account. And with the Bank of England cutting interest rates by a further 0.5 per cent to 4 per cent last week, such accounts are looking less attractive than ever.

An increasingly popular alternative is the protected fund. There is plenty of demand, given the current market environ-ment, and that has prompted the launch of a number of funds in recent months.

JP Morgan Fleming is the latest fund manager to jump on the bandwagon, launching the JPMF Capital Protection Global Growth fund last month.

"So many hundreds of millions of pounds is going into [protected funds], but people are investing in them because they don't want exposure to equities full stop," says Philippa Gee, investment strategist at independent financial adviser (IFA) Torquil Clark. "They don't realise that they are going to lose some money. The problem is that investors don't pay attention to the small print."

Protected funds don't guarantee your returns but protect you from severe stock market downturns. Some are protected so that you cannot lose more than an agreed amount over a set period. Others secure all of your capital and then promise a return based on the performance of some shares. However, this upside is also limited, which is why you should think before opting for one of these schemes.

Protected funds invest most of your cash in equities, but a small proportion – typically 5 per cent – is used to buy derivatives and options that kick in when share prices tumble.

During the recent period of volatility in the stock market, some protected funds have performed rather well. One of the best performing is the Close UK Escalator 100 Fund from Close Fund Management. This guarantees 100 per cent of your capital back at the end of the term; alternatively, you can choose to have 95 per cent of your capital protected. Gains are locked in every three months. Over the past three years, the fund has returned 10.7 per cent compared with the FTSE's -6.8 per cent.

However, this type of fund doesn't always perform so well, which is why many experts avoid them. "We don't really recommend protected funds to our clients because the cost of protection is too high," says Patrick Connolly, associate director at IFA Chartwell Investment Management. "If someone wants protection, we would structure some of their investments for security and others for growth rather than putting it all in one product."

The main criticism advisers have of the funds is that they limit your upside. For example, the JPMF Capital Protection fund returns 100 per cent of your capital after five years plus 75 per cent of all total returns achieved by the linked funds. This sounds impressive, as you get all of your capital back. But you are restricting yourself to a maximum of 75 per cent of any gains. And if the markets do well, this means you will automatically miss out on 25 per cent of the upside.

Equity investors may well be better off riding out the ups and downs of the stock market rather than opting for a "safer" protected fund.

"Most investors are looking to put their money in the stock market for at least 10 years," says Mark Dampier, research director at IFA Hargreaves Lansdown. "If you believe equity markets are going up in the long term – which is why we are investing in shares, anyway – surely you want exposure to the full upside? The only time you should consider buying a protected product is at the top of the market, when it may help protect gains."

So what do you do if you are wary of jumping into the stock market with all your cash? "For the majority of people," says Ms Gee, "a properly constructed portfolio would be better than a protected fund.

Mr Dampier has another solution. "If you have £100,000 to invest and are nervous about the market, you should leave £90,000 in cash and put £10,000 in shares."

The Financial Services Authority, the City watchdog, has issued warnings about some types of protected fund. The FSA is concerned that many investors buy the products without fully understanding what they are investing in.

If you do think it is worth paying for a protected fund, read the small print carefully and ensure you know exactly how your returns will be calculated before piling in. You will have to pay more in charges than for the average growth unit trust: 4.86 per cent in upfront charges, compared with 3.92 per cent.

Try not to be blinded by selective performance figures. Remember that by investing in short-term protected funds for, say, three years, you jack up the risk. But if you pick a protected fund with a longer investment term – usually five years – and quit early, you are unlikely to get all your money back.

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