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The high cost of capital guarantees

Created:
10 September 2008
Written by:
Moira O'Neill

The Investment Management Association, which represents the fund management industry, is getting hot under the collar about the increasing popularity of structured products called guaranteed equity bonds (GEBs), that are luring investors away from traditional funds.

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Investors worried about stock market volatility are flocking to GEBs because they offer both a return related to growth of the stock market and a guarantee against capital loss. But these products should not be taken at face value.

The IMA has taken performance data from National Savings & Investment's five GEB issues since April 2007 and compared them with the return from a FTSE 100 index tracking fund.

The interesting comparison shows that after taking account of the typical 1 per cent annual charge in the index tracker, GEBs are underperforming the stock market by about 4.5 per cent a year. Fine, you may say, this is to be expected from a product that only gives you a proportion of stock market uplifts. But then examine the underlying reasons why you are buying - to do a bit better than sticking your cash in the building society.

Richard Saunders, chief executive of the IMA, points out that the 4.5 per cent performance margin is very close to many economists' estimates of the current "equity risk premium". In other words the returns from GEBs can be expected over time to be much closer to risk-free investment such as cash deposits and gilts than to the stock market. Why bother, you now think? Oh yes, the guaranteed capital.

But while GEBs offer a guarantee against the index falling over a five year period, the IMA points out that that is a relatively unusual event. Before 2002, the last time it was down over five years was in 1978.

Although structured products can help investors to sleep well at night, there are other reasons why you may think twice about them. They aren't always transparent, for example, it can be difficult to find out who is the counterparty guaranteeing the capital. There is also an opportunity cost - you don't get the return from dividends. For this reason, Rob Pemberton, investment director at HFM Columbus Asset Management, is not keen on products linked to FTSE indices.

But I don't want to be too negative as there are many exciting structured products from niche players such as Quantum Asset Management (www.dawnaydayquantum.com) that can play useful roles in your portfolio. Mr Pemberton says: "Structured products are good for high risk/high reward asset classes, especially those that don't have income streams, for example commodities and emerging markets where you don’t get much of a yield."

For a tour of the best structured products, see next week's issue.

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