Protected and guaranteed funds offer investors a certain amount of security when the market starts to get bumpy
Protected and guaranteed funds are almost an asset class in themselves ' offering equity-linked performance when markets rise and limiting the downturn should they fall.
They are usually positioned somewhere between a pure equity product and a money market fund and are ideal if investors want equity market exposure without equity risk. By utilising financial derivatives, these funds are able to set 'safety nets' below which the investment value cannot fall.
Guaranteed funds are primarily close-ended products with a fixed term to maturity (usually 3-5 years) and promise to return the initial capital outlay at the end of the term. There may be a combination of income or capital growth during the term, which are not necessarily guaranteed.
Depending on the level of risk tolerance, the capital guarantee component may be relaxed to 95-90% or even lower. The extra risk taken goes toward seeking higher income or capital growth. Most guaranteed funds are based on equity indices (FTSE 100, Stoxx 50 or S&P 500, for example) but more and more innovative products are appearing. These include products that are performance related to a number of indices, a basket of stocks, or the specific behaviour of the underlying asset during the term.
The attached guarantee is legally enforceable. These guarantees are usually offered on the strength of the issuer's name and are therefore subject to default risk (failure to pay-up). Third party guarantees can be obtained to add an extra layer of protection but this will also add to the cost. There is undoubtedly great marketing appeal to the word 'guaranteed', and some investors will be happy to live with any implicit costs of the guarantee in exchange for the extra comfort that it adds.
Protected funds and guaranteed funds are similar, with the main difference being the legally enforceable guarantee involved. Unlike most guaranteed funds, protected funds apply capital protection on a quarterly basis.
This feature enables protected funds to ratchet up gains during volatile markets. In practice, protected funds are mostly open-ended structures where daily dealing is available, allowing investors in and out at any time. Whereas a guaranteed fund invests in longer-term instruments, protected funds like Govett UK Safeguard and Govett UK Equity Safeguard would invest in shorter-term ones.
There are a number of reasons for including protected and guaranteed funds within an investment portfolio, as these products provide smoothed returns from the equity market, appropriate to a wide range of investment applications. If a client can be sure that he/she can invest and forget their money for five years or more, then tracker funds will often provide a sound return. However, if an investor needs ready access to their money, then protected funds can reduce timing risk, particularly in a falling market. Nobody wants to break into their investments when the market is low. Since protected funds exhibit inherently lower volatility, investors can rest assured that they will not suddenly lose a big chunk of their investment if the market nose-dives at the moment they urgently require cash.
These funds normally appeal to cautious investors or those who want to switch to a more cautious approach. They are useful products for investors who want the potential for higher gains than those offered by banks and building societies but do not want to expose themselves to the wild swings of the stock market. This is particularly true for investors with sizeable outgoings in the future, such as school/university fees, mortgage redemption and elderly care costs, who want good yet stable returns.
Interestingly enough, at the other end of the spectrum, investors who have secured a very good return from the stock market but are worried about potential downturns do not have to withdraw from the market to protect their gains. Instead, they can use a protected fund to temporarily 'park' their assets during a period of market turbulence, thereby maintaining some market exposure, albeit with much reduced risk.
One of the most interesting areas where these funds can be used advantageously is in retirement savings.
More and more people are supplementing their pensions by building up a nest egg of stocks and shares. As retirement gets closer, the 'safe' thing to do would be to gradually switch out of equities into fixed-income investments. However, certain investors may still want some exposure to the stock market. They could therefore take advantage of some form of protected strategy: investing in a protected or guaranteed fund would continue to give them equity-linked returns while limiting potential losses.
A similar argument applies to defined benefit pension schemes. These funds are big pots of money representing payment in-lieu to the future pensioners of the scheme. Traditionally, as the age profile of the scheme matures, these funds reduce their equity holdings and subsequently increase their bond (fixed income) holdings. This balancing act is aimed at matching the defined outgoings to pensioners and protecting the benefits of the nearly retired.
Protected funds (and guaranteed funds to an extent) make a good transitional asset class between equities and bonds. Investments in these funds reduce cashflow uncertainty without compromising on inflation-linked returns. Many pension funds invest in index-linked gilts to match salary-related benefits, but these instruments are in short supply. Protected/guaranteed funds should be considered as good alternatives to Index-linked gilts without the supply constraint.
There are two main types of protected/guaranteed structures ' quarterly rolling and protected equity funds. The first (and longer established) places investor money into cash deposits. Stock market exposure is achieved through equity call options that are renewed every quarter. If the stock market rises strongly, the call options will produce a gain linked to this rise. If the stock market falls sharply, then the call options are worthless but the value of the fund is relatively unscathed because most of it remained in cash.
The second variety invests almost all of its money directly into equities and protects the portfolio by investing the remainder in put options. This type of option gains in value if the stock market falls. If the overall market rises, then the value of the share portfolio will rise. If it slumps, then the put options payout will compensate for most of the losses on the equities, depending on the level of protection selected.
In the current uncertain market environment, equity investors are torn between potentially large capital losses by participating, and the opportunity cost of missing out on a big upswing by pulling out. Many investors, frightened by the recent market performance, particularly in technology stocks, have moved towards lower risk investments.
Those who have seen their portfolios lose over half their value will find it nearly impossible to rebuild their losses through cash instruments. Past data suggests that equity markets move in cycles and, in the long run, equities tend to outperform the cash and bond markets. Therefore, equity participation is important, and protected-equity vehicles are essential in the current environment. Protected and guaranteed funds help reduce the damage in guessing when the markets stop falling and start to rise.
It should be noted, however, that continuous protection on equity funds does not come free or cheap, and when the stock market does bounce back, a protected or guaranteed fund is unlikely to match its performance. If markets continue to fall, however, investors are safe in the knowledge that their fund should not fall as far.
• When the stock market bounces back, protected funds are unlikely to match its performance.
• There are two main types of protected/guaranteed structures ' quarterly rolling and protected equity funds.
• Continuous protection on equity funds does not come cheap.
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