For investors of a nervous disposition

Fund managers use a range of guaranteed funds to tempt nervous investors into the stock market. But as Paul Slade argues, even in a case like October's share price plunge, the value of these guarantees can be more apparent than real.

Many building society savers know that the stock market is where the best returns are to be found, but still do not quite have the nerve to put their money into a traditional unit trust. They saw the stock market plummet in the 1987 Crash, watched appalled at the market's ridiculous gyrations at the end of last month, and conclude it is all too risky.

The industry has responded by launching a range of equity funds which either promise your capital sum cannot fall over a period of five years, or lock in your gains every few months by regularly setting a floor price which your units cannot fall below. These are usually marketed as "guaranteed", "protected" or "capital secure" funds.

Such products are a powerful sales tool for fund managers, as they provide nervous investors with just enough reassurance to take the plunge into equities. But the guarantees they offer come only at the price of reduced performance, and the chances of those guarantees ever being triggered is next to zero. Some funds provide the guarantees by withholding part of your cash from the equity market, using derivatives to cover the risk instead. Others retain the dividend income you would otherwise get from your shares - currently about 4 per cent a year.

Independent financial adviser Amanda Davidson, a partner at London-based Holden Meehan, says: "Nothing comes for nothing and that's as true in the investment world as anywhere else. If you're getting something that looks as if its shoring up your potential losses then you're paying for it somewhere along the line.

"I'd prefer most clients to be investing in ordinary unit trusts or investment trusts and let them take the full risk and the full reward. These things are very finely costed and, if the guarantee is likely to be invoked, they're probably taking more out of the client's investment."

The market's dramatic moves at the end of last month provide a perfect opportunity to illustrate how these funds work in practice. Let's take the example of Tuesday 28 October, when the FTSE 100 index of leading shares plunged 457 points as soon as the market opened.

Even at this nadir, five-year guarantees - had such products existed in 1992 - would have been irrelevant, as the market remained well above its level five years ago. On 28 October, when the market recorded its lowest closing price, the FTSE 100 share index remained 79 per cent above its level on that date in 1992.

If any guaranteed fund's floor price were to come into play as a result of the 28 October fall, you would expect it to be one of the funds which reset its floor price every quarter - the most frequent re-calibration available. These funds would have come closest to setting the floor price which applied on October 28 while markets were at their peak.

AJB Govett's UK Safeguard unit trust, for example, last set its floor price on 19 September 1997, at a level of 136.83p - equivalent to 98 per cent of the bid price on that day. The bid price is the price at which a fund manager will buy back units from investors.

Units in the AJB Govett fund are valued daily at 10.30am, which means the 28 October valuation came while markets were close to their worst point. That day's bid price was 135.94p, nearly a penny below the floor value.

By the next day, the bid price had already climbed back to 138.23p and by 3 November had climbed further to 138.74p. By 7 November it had fallen back to 137.69p. In fact, the Govett guarantee can be used only at the end of each three-month period, and so will kick in only if units are worth less than the floor price of 136.84p on December 19 this year. In effect, the drop on so-called Red Tuesday was cancelled out by the subsequent recovery.

Independent financial adviser Graham Bates says: "Where you're looking at repricing every three months, it's possible investors will have seen some benefit in the very short-term. But, of course, because the market jumped again so quickly, it could only have applied immediately after the major market fall on the morning of Tuesday 28 October. Only an absolutely panic-stricken investor would have sold then."

Of course, that picture can change. As many experts recognise, the biggest falls seen in UK stock markets over the past 15 years have tended to take place in brief flurries lasting days or weeks, accompanied by relatively depressed share prices for a few more months until a recovery is under way.

If share prices were to drop by, say, more than 10 per cent and then stay at that new level over the prescribed three-month re-pricing period, the maximum loss of most guaranteed funds would be pegged at 5 per cent, the amount put in risk during that time, limiting the downside. They would then have the chance to regain in value during the next three months.

One further disadvantage of guaranteed funds is that they often tend to place pre-agreed limits on the investment period. But if markets were to fall by 5 per cent, and then another 5 per cent in the final six months before the fund matures, the total 10 per cent loss has to be borne. By contrast, a typical investor might prefer to ride out the rough patch and wait for a more propitious time to dispose of his or her unit or investment trusts.

Few funds, one of them being the Close Escalator Fund, allow a no-exit limit whereby gains - and losses - can continue to be locked in ad infinitum. The Close Fund, however, tracks not just the UK and/or the US markets, but a range of indices around the world, including Japan, the Far East and Australasia.

Don Clark, another IFA, agrees that guarantees are often not very good value, but makes one exception. If you know you will need a set amount of money at a certain date in the future - for a family wedding, perhaps - he says it may be a good idea to switch to a suitable guaranteed fund about 18 months before the event so you know the minimum amount will be there when you need it.

Ms Davidson adds: "There are some people who just sleep easier knowing there is a guarantee there, and if that is the case, then it's worth paying for. Many clients may not realise the full price they pay, such as loss of dividends, but I think most are canny enough to know you don't get anything for nothing."