August 6, 2007 / 11:16 AM / 12 years ago

Portfolio protection for sale - but at what cost?

LONDON (Reuters) - Stock market volatility is back — prompting some investors to try to protect their portfolios.

Stock market volatility is back -- prompting some investors to try to protect their portfolios. REUTERS/Ian Waldie

Jitters that a spill-over from the troubled U.S. housing market would hit global growth have triggered a two-week sell-off in world stocks.

Even if financial markets are calming, volatility threatens to end the easy financing of corporate takeover deals — a key factor behind the four-year stock market boom.

Jeremy Tigue, manager of the 2.6 billion pound Foreign & Colonial Investment Trust concedes the “cards are stacked towards a further correction”.

“Stock markets are increasingly unsettled with ever more erratic swings in share prices,” says Tigue, whose portfolio has become more defensive in recent months.

Is now the time for investors to consider protecting their portfolios against stock market slumps?

There are myriad “capital guaranteed” and “protected” investment plans, which give exposure to equities, but put a floor below which the value of holdings cannot fall.

While some such plans give full capital protection, others return only most of the original investment if markets drop.

Andrew Norton, head of alternative investments at Halifax Financial Services, says: “Many cautious investors like guaranteed capital plans, because they offer the potential gains of the stock market without the risk.”

These plans typically combine equity options and a fixed return element.

So, say you invest 100 pounds. The investment manager would invest, for example, 70 pounds in a five-year fixed income product, so it can guarantee to return 100 pounds at maturity.

It would then buy equity options with the remaining 30 pounds — less its charges — to give exposure to share markets.

Independent broker Bestinvest currently rates Barclays’ five-year “guaranteed FTSE account” and Morgan Stanley’s “FTSE protected growth”, both of which give full capital protection.

The former — open for subscription until the end of this month — gives up to 120 percent of any rise in the FTSE 100 over a five-year period.

The investment will close after two-and-a-half years if the index has risen by 20 percent or more, but will return 100 percent of capital, less charges, after five years if the index falls.

Meanwhile, the Morgan Stanley product — open for investment until August 17 — offers up to 160 percent of growth in the FTSE over six years.

It will close early after three years if the index has risen by 30 percent or more.

Both products can be held within an individual savings account or pension portfolio via a self-invested personal pension or small self-administered scheme.

Other such “structured” products aim to offer greater flexibility.

Royal London’s “Riley” fund splits investments between equities and an insurance fund.

Aimed at cautious investors who want to take some risk, the lump sum investment runs for five years, with the option to roll over, and is linked to the FTSE 350.

A growing band of life companies — mainly American — are also moving into the structured products field, offering “third-way” pension products, which aim to give the income certainty of an annuity and the potential for growth of an income drawdown scheme.

Annuities, traditionally bought at retirement, give a set or rising income for life in exchange for a lump sum, while income drawdown allows pensioners to draw an income from their retirement fund, while leaving it invested.

U.S. firms the Hartford, Metropolitan Life and American International Group have brought third-way products to Britain, the third largest retirement market behind the States and Japan.

Britain’s Scottish Equitable has a similar product. Its “5 for Life” guarantees a fixed 5 percent income for life, with stock market gains being “locked in” at regular intervals.

Michael Kalen, president and chief executive of Hartford Life, said its guaranteed retirement income plan “took off after the stock market bubble burst in 2001”.

“Some people lost up to 50 percent of their portfolio overnight and that really woke up investors to the dangers of being too heavily in equities.

“Guaranteed drawdown pensions allow people to remain invested in equities and benefit from their potential upside, while protecting the value of their fund in bear markets.”

However, such guarantees come at a premium. Charges tend to be higher than for other investment funds.

The fact that returns on some plans, such as the Barclays and Morgan Stanley products, are based solely on the index price and do not include dividends can also thwart performance.

The same goes for market turbulence — precisely what such products aim to offer shelter from.

“Volatile markets usually cause options to become more expensive ... meaning less upside exposure can be purchased,” says Justin Modray, head of communications at Bestinvest.

So, some products can “struggle to keep pace with low-cost tracker funds in rising markets and during modest falls”.

The relative complexity and tarnished history of products that aim to control risk — with-profits investments and precipice bonds to name two — is also turning independent financial advisers (IFAs) and their clients away from the burgeoning structured products market.

Alasdair Buchanan, head of communications at Royal London, says: “It has its place, but selling to the right people is crucial and can be difficult, due to the complexity.

“Some IFAs are really on board, but others don’t like structured products.

“They’ve been burnt by precipice bonds, think the cost of the ‘insurance’ is too high and say they would rather their client has a well-balanced portfolio — that, they say, provides ‘protection’,” Buchanan said.

Andy Gadd, head of research at Lighthouse, agrees.

“If you’re a long-term investor with a balanced portfolio then you will not want to seek capital security or downside protection.

“Risk is part and parcel of seeking higher returns and any downside protection will always have a cost,” Gadd said.

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