Investors running scared of the stock market are being tempted by "guaranteed" investments, but the guarantees are not what they seem. Consumer champion Which? has slammed some of them this week, warning that the investments can be riskier than they appear.
James Daley, editor of Which? Money, says: "When stock markets are falling and banks are going bust, the offer of a 'guarantee' on your savings or investments can be very appealing, but guaranteed investments are not always what they appear to be. Although not all protected investments are bad news, phrases such as 'capital guarantee' and '100 per cent protection' are bandied around far too often, and don't stand up to scrutiny. We'd advise people to beware of products which make such a bold claim – unless they're backed by the Government."
Which? highlights so-called structured products – a type of investment backed by banks often known as guaranteed equity bonds – as being confusing, complex and costly. They promise investors stock-market-linked returns without putting their capital at risk. But that can mean returns are minimal or non-existent, despite the "guaranteed" tag.
It's because most have a fixed end date at which returns are calculated. The fixed nature of that means investors do not have the option of waiting for markets to recover if the investment has not performed as they hoped. So the guarantee only relates to the cash invested, not to the predicted returns.
More seriously, some "guaranteed" investments are not covered by the Financial Services Compensation Scheme (FSCS). This can prove particularly costly, as the 6,000 British people who had a structured investment with US bank Lehman Brothers at the time of its collapse discovered. Because the investment was not protected by the FSCS, they ended up with nothing.
Even if a structured product is protected under the scheme, the protection is limited, normally to £50,000, but the investments are often targeted at people who want to invest much larger sums – which can mean they are putting the majority of their savings at risk.
"A guarantee is only as good as the company providing that guarantee," points out Adrian Lowcock, senior investment adviser at Bestinvest. He points to the fact that anyone invested with massive global insurer AIG was left sweating on their cash despite the guaranteed nature of the investments. "If the US government hadn't supported the company, their guarantee would be worthless," he says.
So while it's easy for a bank or insurance company to offer a guarantee to keep your money safe, if it goes bust, you could face a battle to get your money back. The 6,000 investors hit by the collapse of Lehmans had actually bought their products through Legal & General, which in turn had sold them through Bradford & Bingley and Alliance & Leicester branches.
"This is known as counterparty risk," explains Ed Bowsher of lovemoney. com. "Normally, the guarantee isn't provided by the plan provider itself. Instead, a guarantee is provided by a third party. If that third party goes bust, investors can end up losing all of their money."
Apart from the risk of the company proving the guarantee going bust, there's also the fact that there's a trade-off for the guarantee. So if your capital is guaranteed, that will normally mean you will have to settle for less potential growth. Typically, a guaranteed equity product will limit the growth you can gain to a percentage of the stock-market growth over the investment period. That could be as little as 40 per cent of stock-market growth.
"Whenever a product is being offered with a guarantee, there is always a price to pay," warns Lowcock. "Frequently it will be a capped performance should the stock markets rally or rise. Often, these products play to investors' fears, offering downside protection when the markets have fallen, while also providing an attractive rate of interest during that period.
"But even though they may appear to offer more attractive returns than a deposit in a bank, they are not so appealing compared to other investments when you consider the minimum timescale the investment has to be held for – often five years."
In other words, locking yourself into a guaranteed return could mean missing out on stock-market growth, which would effectively mean your investment was guaranteed to fail. Right now, that's a very powerful reason for avoiding guaranteed investments, says Ed Bowsher.
"I think there's a strong chance that the stock market will rise over the next five years," he says. "If that happens, it makes sense to receive all of the profits. In other words, put your money in a stock-market tracker. There's a risk that the stock market will perform poorly over that period, but if you buy a guaranteed equity bond, you risk partially missing out on a period of strong stock-market growth."
If you are still attracted by the idea of a guarantee, then maybe you shouldn't be thinking about investment in the stock market in the first place. If you really don't want to risk your money, maybe it would be better to put it into savings accounts – keeping no more than £50,000 in one financial institution to make sure your money doesn't fall outside the protection of the Financial Services Compensation Scheme.
Even if your capital is guaranteed and you get it back intact after, say, five years, you have to take two factors into account. First, there is the inflation effect. Even at its current low level, your money will still be worth around 11 per cent less after five years.
There's also the lost opportunity. If you had put the money into a savings account paying, say, 3 per cent a year, then with compound interest your money would have grown by almost 16 per cent over five years.
There are also other drawbacks, says David Kuo of fool.co.uk. "Guaranteed products usually come with a hefty fee. The lowest fee for a stock-market index tracker is 0.15 per cent, for instance. But guaranteed products can cost as much as 5 per cent of your original investment, which is 33 times higher.
"There are two important rules to remember about investing. The first is there are never any guarantees. The second rule is to never forget the first rule of investing."
The confusion surrounding the term "guarantee" which is attached to savings or investments means it's time for the Government to crack down on firms that offer the products, says Andrew Hagger of moneynet.co.uk. "There needs to be some clarification for investors as to what a guarantee entails. It is time for the introduction for some kind of Kitemark which can only be displayed if certain criteria are met – for instance, if you are guaranteed to get 100 per cent of your initial capital back as a minimum and also that the first £50,000 is covered under the Financial Services Compensation Scheme.
"Ever since the collapse of the Icelandic banks, safety has become more important than the rate of return for many savers, so it's time to get the labelling right. All we need is the financial services' equivalent of 'Ronseal', with an easily identifiable logo that signifies that you're guaranteed not to lose a single penny of your capital investment."
Get back... what you're entitled to
What compensation would you be eligible for?
The Financial Services Compensation Scheme will pay out up to £50,000 for money saved in a UK bank or building society and £48,000 for an investment product. In addition, the FSCS will pay out 90 per cent of any pension or insurance claim. You will find full details of compensation limits and how to claim at www.fscs.org.uk.
If you save money or invest through foreign-owned companies, you may first have to claim from an overseas compensation scheme.