Safety first? Not in shares

Protected funds might give you peace of mind, but are you losing out on returns?

Those who enjoy a rollercoaster ride no longer need to go to a fairground for the experience. They can just buy a few shares, strap themselves in and gear up for a ride on the stock market.

Those who enjoy a rollercoaster ride no longer need to go to a fairground for the experience. They can just buy a few shares, strap themselves in and gear up for a ride on the stock market.

Recent market turmoil has led many investors to shun new equity investments in droves. Sales of mini cash individual savings account (ISAs) have been booming as investors take the safe option and choose cash over shares.

There was a slight upturn in the market at the beginning of last week but this is by no means guaranteed to continue. According to some market watchers, volatility is far more likely in the coming months.

"In the near term, over the next few days, the market will be pretty choppy," says Jeremy Batstone at NatWest Stockbrokers. "Then we should see a spike up [in prices] which could be very aggressive and last several weeks. But if expectations for corporate-profit growth are not met, there could also be a sharp fall afterwards."

With such volatility a strong possibility, it is no surprise that fund managers are promoting protected funds. But is it really possible to safeguard our investments without missing out on stock-market highs?

Neil Lovatt at Scottish Life International (SLI), which offers a wide range of protected funds, believes investors can control the risk of investing in equities while enjoying stock-market returns. SLI offers Protected Index and Protected Deposit funds, allowing investors to choose between 95 and 100 per cent capital security on UK, US, Japan or Europe trackers, or a multi-index fund.

SLI recently launched protected.com, which allows investors to participate in the growth of the Nasdaq 100 with a defined level of capital protection. So even though the market has fallen 32 per cent since the beginning of the year, your investment would not have suffered to the same degree.

"It is all about risk control rather than protection," says Mr Lovatt. "Critics say investors in protected funds lose on the upside of the stock market. But that is not true with the 95-per-cent-protected fund, although it might be if you are 100 per cent capital guaranteed.

"But with a risk profile of 95 per cent, returns can be very similar, if not above, the equity market the fund tracks. The risk profile of such a fund is very similar to that of equities: it is not entirely suitable for someone who is very risk averse."

Investors who choose 95 per cent capital protection can benefit from up to a 150 per cent rise in the market their fund tracks. Those who choose the 100 per cent capital protected fund will see much lower returns – of up to 30 per cent.>

Not all independent financial advisers (IFAs) are convinced by protected funds. Mark Dampier, head of research at IFA Hargreaves Lansdown, says that they suit only a certain type of investor.

"Tactically they could be useful, if the market is high and you are three years away from retirement, for example," he says. "But really now the horse has already bolted. The time to invest is when the market is high, because when shares have fallen a long way, surely you want maximum exposure."

If you are really worried about the future direction of the stock market, Mr Dampier suggests moving out of shares as far as possible. "If clients are worried, they should put £95,000 in the building society and invest just £5,000 in shares. It works in the same way. Anyone who is very cautious should have more money in cash and reduce their equity exposure."

Out of all the protected funds on the market, Mr Dampier prefers the Close Escalator range, managed by Close Fund Management. Investors can choose between a range of funds and protect either 100 per cent or 95 per cent of their capital from stock-market falls. Gains are locked in every three months.

Some advisers refuse to recommend protected funds at all. Patrick Connolly at IFA Chartwell Investment says: "We don't like them. They get talked about when the markets are volatile and it is true that when markets are going down, your losses are going to be less. But you pay for protection in the form of ongoing performance. The cost of protection is too high."

Since its launch in January 1995, the Close UK 100 Escalator Fund has grown 30.6 per cent, compared with 42.3 per cent for the FTSE 100. Clearly some of the highs have been missed but if the market had fallen, so too would the lows.

If you really are determined to opt for a protected fund, Mr Connolly suggests that you check its performance in recent years. "[Protected funds] tend to outperform more in the short term than the medium term, which is how long you should aim to be invested for," he says. "It is worth asking how they have performed over the past five years. You would expect the same going forward.

"If investors are more cautious, they should look for alternative investments such as with-profit bonds."

* Contacts: Scottish Life International, www.sli.co.im; Close Fund Management, tel: 0800 269824 or visit www.closefm.com