Learn a new language: Square Mile speak

This week sees the start of our new investment series. Over the next six weeks we will look at different investment vehicles, explain what they are and which investors they are suitable for. We start with protected investment products.

We live in uncertain times. Who could have predicted at the start of this year that we would be ravaged by a fuel shortage in September or - even more improbably - that England would have beaten the West Indies at cricket? For investors, uncertainty over stock market movements is a constant source of anxiety. Yet investment experts never tire of telling us that to see our money grow at a healthy rate, it must go into the market.

We live in uncertain times. Who could have predicted at the start of this year that we would be ravaged by a fuel shortage in September or - even more improbably - that England would have beaten the West Indies at cricket? For investors, uncertainty over stock market movements is a constant source of anxiety. Yet investment experts never tire of telling us that to see our money grow at a healthy rate, it must go into the market.

Cash deposits can't keep pace with inflation, and while bonds may provide a decent income, they can't provide sufficient growth. For the more nervous investor, a guarantee that you can invest in the stock market without losing the shirt off your back would be a godsend. This is exactly what protected equity funds and guaranteed stock market bonds claim to offer. Both types of investment promise to protect all, or a large part, of the initial capital you invest, while allowing your money to grow.

As good as this may seem, remember the adage about a free lunch: there is no such thing.

Guaranteed bonds issued by banks, building societies and insurance companies are fixed-term investments which protect 100 per cent of your capital. Any growth is linked to the performance of an index, such as the FT-SE 100. There is usually a cap on the maximum growth, regardless of how far the FT-SE rises. For example, Abbey National recently launched a Safety Plus Growth individual savings account (ISA). The five-year bond guarantees the return of your capital plus 20 per cent. Investors can receive returns of up to 65 per cent of the rise of the FT-SE 100 - but no higher.

Protected equity funds are equity-based investments with a safety net. The fund manager limits the potential downside on your fund, usually to around 5 or 10 per cent, while still offering stock market growth.

Both bonds and protected equity funds rely on options to protect your capital. Options are a type of financial derivative, used to hedge against a downturn in the market. Do not let the use of derivatives put you off protected products, which were subject to bad press in the 1990s, largely because of the Nick Leeson affair. They are not inherently risky products if used to hedge, but should be avoided if speculating along the lines of Mr Leeson.

Options are used in different ways to safeguard your investment. Some protected equity funds, like Deutsche's All Weather Equity Growth Fund, invest most of their cash in equities. This provides the growth. The rest of the money is used to purchase options, which can be "called" if the market crashes - this provides the protection. Others, such as the Escalator funds offered by Close Brothers, do not invest in equities at all; they place most of the money on cash deposit, giving investor protection, using the rest to purchase options for the growth.

The problem with protected equity funds is that they do not perform as well as standard unit trusts invested in equities, as the cost of buying the options to protect your capital is relatively high. The more volatile the stock market, the more expensive the options become.

"You pay a very high price for protected funds," says Jason Hollands, deputy managing director of independent financial adviser (IFA) Best Investment. "We estimate that investors can be paying as much as 7 per cent per annum in order to get the protection which these funds offer."

Marc Gordon, managing director of Close Brothers, defends protected equity funds, arguing that while they may not replace standard unit trusts, they do have a role to play.

"When people criticise protected funds, they are usually comparing apples with pears," he says. "We are not saying that you should not invest in equities, but that you should not put all your wealth into equities without some protection."

He adds that anyone considering buying a with-profits fund would do better with a protected fund. "Essentially, they do the same thing. They reduce risk and volatility while giving good, steady profits over time. But with-profits are an outdated and inflexible tool for saving. With a protected equity fund, gains are locked in more regularly, the gains are transparent, because they are linked to an index, and you can sell the fund whenever you like."

Advisers argue that most investors should look at investing over five years if they choose equities. Over that time, they say, you are more likely to see your money grow in a unit trust than in a protected fund.

Mark Dampier, research director at IFA Hargreaves Lansdown, said: "Protected funds fall between the sentiments of fear and greed. [They] guarantee that if the market falls, you will lose money, but not as much as everyone else, and if it rises, you won't make as much as everyone else."

Advisers are sceptical about fixed-term products. They point out that although Abbey National's bond offers a minimum return of 20 per cent, this is only equivalent to 4 per cent growth a year. Ultra-cautious investors can do better simply by choosing a good savings account.

Independent Partners; request a free guide on NISAs from Hargreaves Lansdown

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