Personal finance: A soft landing in a crash

How do small

players protect

themselves

against share

falls without

losing any

chance of gain?

Iain Morse and

a panel look at

the options

WILL THEY, won't they? Most fund managers agree that share values look over-priced, but none will make a prediction about exactly when markets will fall, or by how much.

What cannot be disputed is that the last four years have been good for private investors buying retail financial products such as PEPs and unit trusts. Over this period, the value of the FT-SE All Share Index, measuring the prices of all shares traded on the London Stock Exchange, has just about doubled.

With almost three-quarters of actively managed UK funds failing to beat the index, even the poorest performers have had their values dragged up by a surging market.

So at this stage in the bull run, with making money on shares starting to look just a little too easy, at least some investors can be forgiven for switching to the defensive.

For those with large share portfolios a discreet phone call to their stockbroker will suffice; shares can be bought and sold, gains realised. But for the majority of us with packaged retail products the big question is whether you can have your cake and eat it, buying into funds that protect your capital if share prices fall, but which also give a share of gains if they continue to rise. Our panel of financial advisers were asked to build portfolios on this basis, each investing pounds 20,000 for medium-term growth over five years or more.

Some common themes emerge. Among these are capital-protected unit trusts, such as Edinburgh Fund Managers' Safety First Fund. Funds of this kind are estimated to make up 40 per cent of new unit trust sales. Most offer to protect between 95 and 100 per cent of the initial investment.

Edinburgh's fund does this by buying directly into shares, but also taking a bundle of derivatives - options to buy or sell against future FT-SE values - which limits risk on the fund. Other protected funds give a guarantee by buying zero coupon bonds - forms of debt issued by large companies - which pay no income but return a fixed sum of capital.

But insuring against the downside means selling away the potential for upside gains. Neither Safety First nor other funds in the same category have managed to keep up with gains on the index since launch. In the 12 months to April 1998, FT-SE 100 share values grew by 24 per cent, while EFM's fund-managed by just over 10 per cent.

High-income funds, mostly PEP-able, combining high-yield equities with corporate bonds and gilts, offer another two-way bet on equity values. Bonds and gilts mostly have fixed redemption values, giving an element of capital security.

Share prices have risen, pushing yields down, and some argue that in the event of a market connection, higher yielding shares will have a shorter distance to fall. This is controversial, but in practice retail high-income funds offer a route to recoup losses from a market fall, as long as they are held over the medium term with income reinvested to buy more fund units against a market recovery.

As their name implies, split capital investment trusts offer at least two classes of share to investors and, depending on which you choose, can offer low-risk capital returns. Zero dividend preference shares pay no income, but a fixed sum of capital at their redemption date, typically five years from issue.

This is not risk-free investment. "Zeros" are repaid before any other class of share in the trust, but should only be bought at a discount against redemption value. The amount repaid also depends on the success or failure of the fund managers, and in theory you could get less than you have invested.

Investing into with-profits funds run by mutual life companies through "insurance bonds" found favour with one adviser. These funds can be very large - Prudential's has a value in excess of pounds 24bn - and hold a wide spread of assets, including shares, cash and property. The key attraction is that they smooth out stock market fluctuations over time.

But a little caution is needed: annual bonuses declared by fund managers are discretionary, and may fall in line with a decline in share values. Also, all with-profits bond contracts include a clause allowing the application of a market value adjustment factor to withdrawals in adverse market conditions. This amounts to a cash penalty on bond encashments until the market recovers.

Another factor to be considered is the cost of switching between investments. Most unit trusts have initial charges of between 3.5 and 5 per cent. Stockbrokers will charge a fee for any advice. With-profits bonds have setting-up costs of 5 to 6 per cent. This means that an existing investment that falls by 10 per cent in value need return only half that amount over the next 12 months for any switch to look like an unnecessary expense.

If you already have money invested, one way to cut costs is by fund switching with an existing provider. Check on which funds they offer, and whether discounts are available. What The Broker Says

Managing director at Greig Middleton Asset Management, a firm of stockbrokers and private client fund managers.

"Currently we would invest over half the portfolio in zero dividend preference shares. These shares are entitled to receive a fixed repayment of capital at a future date. Of the pounds 20,000, we would invest pounds 12,500 in zero dividend shares spread between the following funds: Johnson Fry Utilities, Geared Income Zeros, Jupiter International Green and M&G Income.

A further portion of the portfolio would be invested in certain capital shares of split trusts, where the discount to asset value can act as a buffer against falling markets. Some pounds 2,500 could be placed in a Tor Investment fund.

With the balance we would purchase trusts investing in a broad range of mid-term traded endowment policies, where bonuses that are added to policies cannot be taken away. Two funds that fit this bill are Kleinwort 2nd Endowment Policy Trust 2009 and Kleinwort Policy Trust, into which pounds 5,000 would be placed.

A portfolio of this nature offers a significant tax advantage, since most of the return is in the form of capital. Gains are tax-free for those whose annual capital gains tax allowance has not been used elsewhere. The strategy is not risk free, particularly in the short term. But it has proved resilient when markets fell before."

What The Financial Advisers Say

ALAN STOKES

Director at the Investors Partnership, a firm of independent financial advisers in London.

"If markets were to correct, finding somewhere to hide will be impossible. However, a few basic rules might help avoid the worst.

Invest in quality funds that have portfolios of blue chip stocks which are easily traded. My first choice would be the HSBC Footsie Fund. This invests in the top 100 UK companies, using quantitative sampling. In other words they can choose a limited number of stocks to replicate the index.

Next I would look at funds that offer a dividend yield. My choices would be the Hill Samuel High Yield Trust and the Aberdeen Prolific Extra Income Trust. Both offer yields around 3.6 per cent, and have quality portfolios and sound management teams.

Lastly, it is important to be able to take advantage of any correction. The Mercury Recovery Fund has a proven track record in identifying value. I would invest pounds 5,000 in these four funds."

AMANDA DAVIDSON

Partner at Holden Meehan, a firm of independent financial advisers based in London.

"My investment recommendations are as follows: pounds 6,000 in a corporate bond PEP with M&G and pounds 14,000 in two with-profit bonds with Prudential and Royal Sun Alliance. A corporate bond PEP is less volatile than an equity based PEP.

Dividends are in the region of 7.5 per cent but little capital growth can be expected.

Dividends can be reinvested to provide growth. This is the last tax year to take out a PEP before the advent of the ISA (individual savings account) in April 1999, so some defensive strategy makes sense particularly if other PEPs carry higher risks.

With-profits bonds smooth out the rough ride that equities can give, by adding bonuses that cannot be taken away.

The contract is set up with a view to bonuses being added each year. Bonuses can be adjusted upon encashment if market conditions are adverse. It is sensible to choose two providers to spread investments and risk."

GERARD SEYDAK

Independent financial adviser at the Newton-Barr Partnership, based in Edinburgh.

"Investors would still be advised to expose their capital to equities. Although given the current level of the FT-SE share index, they could invest in a protected unit trust which sets a floor on unit prices below which they can't fall. This protects against extreme market reversals, allows investors to remain invested and is PEPable.

On the downside, you pay for the protection: about 5 per cent of your capital pays for the 'floor', leaving only 95 per cent invested. Edinburgh Fund Managers' Safety First Fund or Scottish Widows' Safety Plus Fund are good examples of this concept.

An alternative would be a small selection of zero dividend preference shares. These normally produce a higher return than bank or building societies and are not as sensitive to short-term market movement as ordinary shares. Exeter Fund Managers have an excellent fund in this area."

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