Discover the low-risk investment formula
In the early 1330s, so the story goes, Nicholas Flamel achieved the ultimate goal in science: he created the Philosopher's Stone, which turned metal into gold, and made himself immortal through the 'Elixir of Life'.
But Flamel was a conman, making his fortune by promising people the answer to their money problems.
Today we have no shortage of alchemists, tempting us with their low-risk investments and promises of good returns. The problem is that so many of them fall short – delivering either higher risk or much lower returns than expected.
The attractions of a low-risk investment are clear. The IMA Investor Confidence Index earlier this year found that 28% of investors aren't prepared to take any risk at all.
Yet with interest rates at a record low, they are unimpressed with the returns available from cash: 53% find it harder now to find a good place for savings than they did a year ago.
In desperation, investors are turning to products offered by modern-day alchemists promising higher returns at low risk – and many are sorely disappointed.
Graham Cooper, a 47-year-old manager from the North West, fell for such a con when he took out a pension through his workplace. He opted for a with-profits investment, as it was a low-risk plan and he stood the chance of a payout if the mutual running the scheme floated.
"I held that pension for 10 years and paid into it on a regular basis," he says. "I'm sure I got statements, but never really picked them up until last year, when I discovered I'd only made about 3% over the 10 years. I'd have been far better off sticking it all in the bank."
He's still paying into the pension, but has switched his investment to a FTSE tracker on the grounds that "at least I know what that's supposed to do".
Graham is certainly not alone in turning to with-profits. After some years in the doldrums, they saw a surge of popularity in the downturn, with £3.4 billion worth sold in 2008. But he's not the only one to be disappointed either; his 3% in 10 years is sadly fairly average.
In fact, the total average return for the last 10 years has been 3.3% – far below the performance of the FTSE once dividends are factored in.
The with-profits structure is one problem. Gavin Haynes, managing director of Whitechurch Securities, says: "Smoothing returns in order to avoid nasty falls was easy in the 1990s when markets were rising, but in the last decade that hasn't been so easy, and performance has been dismal."
There are also concerns that the product is too opaque. Jason Witcombe, an adviser with Evolve Financial Planning, says: "You have no idea how the money is invested, and the bonus rates are set at the whim of an actuary and don't seem to bear any relation to the performance of underlying assets, there may be market-value adjustments imposed, and you have no idea whether or not you'll receive a terminal bonus."
These issues have meant that with-profits have dwindled in popularity since their heyday.
The promise from structured products
An increasingly popular 'low-risk' option is structured products. Sales have soared throughout recent years – according to StructuredRetailProducts.com, sales growth over the last decade has averaged 20.3% a year, and total assets under management now stand at £39.4 billion.
These investments offer a defined return over a set period, provided that a certain investment target is reached. So, for example, you may get a 7% return over the next three years, provided the FTSE doesn't lose more than 50% of its value.
Alternatively, you could be offered 90% of the gain in the FTSE over the next four years and your money back if it falls.
But as Tim Cockerill, head of fund research at Ashcourt Rowan, says: "I'm not convinced retail investors understand what they're buying.
"These are complex investments and each one needs to be looked at in detail on its own risks and merits." This complexity means it's hard to compare products or charges.
In addition, any guarantee depends on the security of the institution backing it. Haynes says: "The latest in a long line of problems with this product has been counter-party risk – the risk of a problem with the person providing the guarantee. We saw that with funds guaranteed by Lehman Brothers."
These drawbacks mean many of the experts rarely or never touch structured products.
Absolute return funds
Another complex option is the absolute return fund. Here, the fund manager can invest in a wide range of assets, and can also use various financial instruments to make money from falling markets.
The first problem is that there's a huge variety of funds. Haynes says: "All the description tells you is that the fund's trying to deliver a positive return in all markets. Some aim for big returns and take large risks, while others are more conservative."
This positive return is not guaranteed, and the more risk a fund takes, the higher the danger that it will fall short.
And as these products have evolved from the hedge fund market, so many have additional performance charges if they exceed their investment goals.
Witcombe says: "The total expense ratio can be pretty horrendous, particularly in a low-return environment." For this reason, the experts only recommend a fairly narrow range of them.
Experts, however, are more positive about managed funds, which invest in a mix of different assets including equities, bonds, property and commodities to spread the risk. Cockerill doesn't use them for his clients but he concedes: "They're a useful one-stop-shop."
They typically deliver an average of around 8% to 10% a year over a longer period, but they are not necessarily low-risk.
Haynes says the problem is their name means people assume they're relatively safe. "You have to understand that these funds can suffer falls in capital and/or income," he says.
So what is the secret?
Of course, in each category there are the good, the bad and the ugly. Although with-profits are widely disliked across the spectrum, Haynes says the Prudential with-profits fund has proved to have long-term potential.
For absolute return, meanwhile, he likes funds with strong long-term records such as Standard Life Global Absolute Return Strategy and Jupiter Absolute Return, run by Phillip Gibbs. Cockerill uses Blackrock UK Absolute Return.
Darius McDermott, managing director of Chelsea Financial Services, rates all these funds, and also likes the Gartmore range.
Among cautious managed funds, Hayes and Cockerill both rate Investec Cautious Managed, run by Alistair Mundy, and Gartmore Cautious Managed. McDermott, meanwhile, likes the Miton Special Situations Portfolio fund, which is in the balanced managed sector.
But while there are some strong products, none can truly match low risk with high return. Investors have a choice between one or the other. You can take low or no risk through a savings account or cash individual savings account.
Over the past 10 years you would have been financially better off doing this, but in more normal times you'll pay the price of lower returns.
Say, for example, you were to invest £1,000 in a savings account paying an average of 4% a year over 10 years, you would make just £490.83. Alternatively, you could take more risk and seek higher returns.
If you were to put it into an equity fund paying an average of 7% over this period you would make £1,009.66 in interest.
One middle way is to structure a portfolio to suit the level of risk you're prepared to take. Witcombe says: "If you're skilled enough, or are willing to pay an adviser, you can structure a portfolio to match the risk and return you are comfortable with."
He says this can be far more cost-effective than 'low-risk' products.
Witcombe is an advocate of passive management, where investments are structured to mirror the performance of a particular index, such as the FTSE 100. There's no clever analysis going on; the manager simply follows rigid rules that stick to the benchmark.
This means that the fund shouldn't either overperform or underperform, and charges can be kept low. Witcombe says this sort of approach can not only more closely match your needs, but also deliver better performance at a lower cost than these commonly marketed alternatives.
There are some products in each of these sectors that can deliver. However, investors need to know exactly what they invest in, how they perform and what they charge, which in many cases is nigh-on impossible.
Ultimately, if you want more return, you need to take more risk. It's a simple rule that has been since Nicholas Flamel himself, and still holds true today – unless of course you happen to be in possession of a Philosopher's Stone.
Structured products offer returns based on the performance of underlying investments. Many products are linked to a stockmarket index such as the FTSE 100 or a “basket” of shares. There are generally two types of product, one offers income, the other growth and investors have to commit their capital for the prescribed term, usually three or five years. The investment is not guaranteed and if the index or basket of shares does not perform as expected over the term the investor might not get back all their capital.
An additional bonus added to a with-profits policy when it comes to the end of the term specified at the outset and “matures”. The terminal bonus is paid as a percentage of the final payout and is at the discretion of the life company and are not guaranteed and the rate changes from year to year depending on the return from the with-profits fund. In some cases, the terminal bonus accounts for half the maturity value of the policy.
With-profits funds are administered by life assurance companies and access to them is through the life company’s products such as bonds, endowments and pensions. Your monthly contributions are pooled with other investors’ money and invested in a mixture of shares, bonds, property and cash. Each year, a “reversionary” bonus (a declared percentage) is added to your investment and a large part of the policy’s final value depends on these bonuses during the investment period. In years when the with-profits fund performs well, some of the return is held back and paid out in years when the fund does badly and this “smoothing” process makes with-profits investments unique. When the policy matures, the life company may pay a discretionary “terminal bonus”.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
Total expense ratio
Most investment funds levy an initial charge for buying the units/shares and an annual management fee but other expenses also occur in running the fund (trading fees, legal fees, auditor fees, stamp duty and other operational expenses) which are passed on to the investor and so the TER gives a more accurate measure of the total costs of investing. The TER is especially relevant for funds of funds that have several layers of charges. Unfortunately, investment fund companies are not obliged to reveal TERs and many only publish the initial charges and annual management charge (AMC).
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
A standard by which something is measured, usually the performance of investment funds against a specified index, such as the FTSE All-Share. Active fund managers look to outperform their benchmark index. Cautious fund managers aim to hold roughly the same proportion of each constituent as the benchmark, while a manager who deviates away from investing in the benchmark index’s constituents has a better chance of outperforming (or underperforming) the index.
A term applied to raw materials (gold, oil) and foodstuffs (wheat, pork bellies) traded on exchanges throughout the world. Since no one really wants to transport all those heavy materials, what is actually traded are commodities futures contracts or options. These are agreements to buy or sell at an agreed price on a specific date. Because commodity prices are volatile, investing in futures is certainly not for the casual investor.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
Absolute return funds
Absolute return funds aim to deliver a positive (or ‘absolute’) return every year regardless of what happens in the stockmarket. Unlike traditional funds, they can take bets on shares falling, as well as rising. This is not to say they can’t fall in value; they do. However, over the years, they should have less volatile performance than traditional funds.