Investments with capital protection carry a guarantee from a financial institution that some or all of the original capital invested will be returned even if markets fall. They usually aim to provide a return in excess of cash interest rates.
Advantages of Capital Protected Investments
The advantages of capital protected investments are:
- They provide a means for low risk investors to target higher returns than those available from a bank account
- They provide a means for low-medium risk investors to protect part of their portfolio from falls in value
Disadvantages of Capital Protected Investments
The disadvantages of capital protected investments are:
- Charges can be high
- Returns may be explicitly or implicitly capped
- Early redemption may be costly or impossible
- The capital protection depends on the financial strength of the underlying guarantor
- Capital Protected Investments usually work in a more complicated manner than equities, bonds or cash
Overall, these products can form a useful part of a portfolio. However capital protection comes at a cost, not only in charges but also in investment returns and accessibility. Investors who can tolerate more risk are usually better advised to avoid capital protected investments and instead focus on controlling risk through diversification.
Types of Capital Protected Investments
The three main types of capital protected investment available at present are:
- Tracker Bonds
- With Profit Funds
- Protected Funds
Tracker Bond investments are typically split into three parts, as follows:
- The largest part, perhaps 80% of the investment, is placed in a low risk interest bearing facility. Over the period of the investment, this is guaranteed by a financial institution to grow to 100% of the value of the original investment. This effectively provides the capital guarantee.
- The next largest part, perhaps 14% of the investment, typically buys a financial asset that gives high risk exposure to investment markets. At the maturity date this derivative could be worth a lot more or it could be worth nothing.
- The smallest part, perhaps 6% of the investment, is paid out in charges.
Tracker bonds will often be marketed as offering the growth from stock markets without the downside risk. However Tracker Bonds do not benefit from dividends, which tend to account for over 50% of the long run return on equities.
These investments tend to offer better terms in high interest rate than low interest rate periods. Investors should always ask who is providing the capital protection for a tracker bond.
With Profit Funds
With Profit Funds are the oldest form of Capital Protected Investment available on the market. The workings of With Profit Funds can vary, but typically growth is awarded in the form of an annual bonus and a terminal bonus paid on encashment. Annual bonuses are typically guaranteed along with original capital if the investor holds the With Profit Fund to its maturity date. The terminal bonus is not guaranteed. If markets perform poorly a substantial penalty may apply on early encashment.
With Profit Funds have, to some degree and with exceptions, fallen into disrepute. The guarantee is provided by the investment company, and if markets fall the investment company will often seek to protect itself by reducing the level of risk taken within the fund. This reduces growth prospects, and arguably does not benefit investors given that they have a capital guarantee anyway.
Following the severe market falls of the 2000-2010 decade, many With Profit Funds have very low growth prospects and carry substantial penalties for early withdrawal. While past investors have benefited from the capital protection in a bad decade for investments, there is little reason for new investors to use these funds, except in a very small number of cases.
After periods of market turbulence, penalties may apply for early encashment of With Profit Funds.
A minority of With Profit Funds carry valuable guaranteed growth rates. In addition some people who hold With Profit Funds in their pension may benefit from valuable guaranteed annuity rates. These tend to be closed to new investors, but those who already hold With Profit Funds or are contributing to them may be well advised to continue doing so.
The label ‘Protected Fund’ tends to be applied to investments where capital protection is partial. For example, a protected fund may offer investment growth with a guarantee that the value will never fall below 80% of the highest unit price ever achieved.
These structures may prove popular for low-medium risk investors who want a limit set on the amount of money they can lose.
Apart from the risk of a limited loss, however, there is another common downside to these funds. Typically the investment company will move the fund away from higher risk investments into lower risk investments when values fall. On the surface this may appear sensible but, from an investor’s viewpoint, they have capital protection anyway and risk within the fund is the only way they can generate significant growth. After significant falls in market value, protected funds can find themselves effectively stuck in cash and bonds, with very limited recovery prospects.
These funds may be a good idea for anyone who wants the possibility of growth with a limit on losses. However a key question to ask is how much of the fund is invested in higher risk, higher growth assets. If it is significantly less than 50%, then you will have to decide if future growth can keep up with cash or government bonds.