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Calculated risk

Matt Goodburn on the dangers and rewards of high risk investments

The FTSE reached a five-year high last week and with the Dow Jones Industrial Average breaking the 12,000 barrier all might appear to be rosy on the investment front.

A the same time, though, influential fund managers, including Fidelity guru Anthony Bolton and F&C stalwart Ted Scott, have said they believe storm clouds are brewing.

Since 2003, apart from the May blip, global markets have enjoyed almost continuous growth, and exposure to direct equity funds has been a positive.

But with confusing signals on the directions of the financial markets, some might say this a good time to consider investing in products that have a capital guaranteed element. Whereas with-profits, with its smoothing function, might have been a popular core holding for many a few years ago – particularly options with a capital guarantee – declining sales suggest advisers are looking further afield.

Arch Financial Products partner Robert Addison says a crucial factor in choosing a structured product is getting the timing right, which is notoriously difficult.

“It is very hard to time the market but if investors are going for a five-year structured investment they should be looking to the long term. People looking at investing in a FTSE Allshare tracker now should try to wait for a small dip in the market and then go in, but it is extremely hard,” he says.

Keydata sales director Mark Owen says he does not believe investors should be looking for full capital protection because current market conditions are not too worrying.

He says: “Four years ago, market conditions were not healthy and people thought equities would stay down, so geared upside products offering built in high protection looked a good bet.

“If people think markets will fall dramatically again, then cash would definitely be a better option.”

Chelsea Financial Services managing director Darius McDermott says while many structured products can offer high exposure to a stockmarkets’ upside, he feels the price the investor pays for a capital guarantee is often too high. But, he notes, the higher the upside an investor wants, the more they will realistically have to pay for any capital protection.

Owen says investors need to be wary of paying a premium for capital protection at a time when markets are doing very little.

He says: “People buy what they think they need at the time but they also need to be careful that they do not buy too much capital protection.

“The worry is if people buy a product offering 75 per cent of the growth of the FTSE with 100 per cent protection and the FTSE does very little that scenario would mean it would be better to have your money in cash.

“In my opinion, a good approach would be to leave some money in cash and look taking perhaps 80 per cent protection. In this case, if the market continues to perform reasonably, you won’t lose out and if it performs well you are likely to receive twice the market return. If it falls 20 or 30 per cent barriers would not be breached.”

McDermott says the impact of timing can be reduced by ensuring structured products are only used as part of a diversified portfolio and goes on to say it is important to consider precisely what the risk and return ratios are.

He says Chelsea is currently recommending one of Abbey’s capital guaranteed equity bonds offering returns linked to the performance of the Japanese Nikkei 225 index to clients who want higher risk exposure.

He says: “There are clients and intermediaries who want access to higher risk products without paying for the risk. In terms of risk Japan is probably 10 out of 10, so people are paying more for the protection and getting exposure to the upside with a capital guarantee.”

Addison agrees that structured products are suitable for a wide range of investors but says the majority might be better off looking for products that have a low correlation with equity markets or low volatility, with a degree of capital protection.

He says some products should be treated with caution by investors, citing reverse convertibles and high income baby bonds as potentially problematic if the market was to fall away dramatically.

He says: “A lot of people sold them in the last bull run and many investors got caught out when the markets went south.”

Addison says older investors nearing retirement might be drawn to protected equity products that could offer decent upside exposure, if they want access to riskier products to increase assets in their pension pool.

He goes on to say that intermediaries have to weigh up their individual client needs but adds if they are looking for a longer term investment that includes direct equity exposure, a less risky capital protected product may prove a useful addition to their portfolio.

Owen says one misconception about some geared products is that investors remain locked in for the complete five year term – they can often access their money without penalty after three years.

In some cases they have managed to bank up to 50 per cent returns on their initial investments despite exiting early, he says.

Whatever solution is finally chosen, the key message is to use each product as just a part of a diversified portfolio.

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