Investors stare over edge of the precipice

The Lloyds TSB fine shows that there are still problems in this highly risky sector

Protection and preservation of capital while attempting to extract the maximum income at minimum risk has been the goal of investors since time immemorial.

For many, these days, that has meant an invidious choice between the devil of so-called "precipice" bonds and the deep blue sea of deposits. Precipice are bonds which promise a return dependant on the performance of certain named stock markets, here and abroad. But if the performance falls below a certain level, the losses can mount at an alarming rate.

Last week's £100m of fines and compensation costs suffered by Lloyds TSB, for mis-selling the Scottish Widows Extra Income Growth Plan, shows how bad the blunders can be. Lloyds' branch staffs blithely persuaded innocents to put their life savings into these plans, with the assurance that they were a conservative way to invest in the stock market.

Scottish Widows is a subsidiary of Lloyds, but inquiries by The Independent show the complaints have not been confined to Lloyds' sales of its subsidiaries' products.

A retired teacher and widow, Barbara Bamford of South Yorkshire, did not wish to risk capital when she went to her Lloyds TSB branch to ask about investments in the summer of 1999. But, as a result of the advice she was given by a Lloyds TSB IFA, she lost £13,000 of £35,000 invested in a precipice bond.

Mrs Bamford, 73, says of the Lloyds TSB adviser: "She spent the whole morning with me. I told her I did not want to lose any of my capital. I won't touch unit trusts, because in 1985 I had put money in a unit trust and it soared then plummeted after two years. So I was against risk."

The adviser sold Mrs Bamford a three-year Scottish Mutual Income Bond, with an annual income of 8 per cent, but return of capital was based on the Dow Jones Euro Stoxx index's performance.

When the product matured this summer Mrs Bamford was shocked to see her £35,000 had turned into £22,000. Convinced the risk had not been properly explained to her, she contacted her solicitor who called in David Brashaw, an adviser at the IFA Inter-Alliance.

Mr Brashaw got no positive response after two complaints to Lloyds TSB, so he helped her complain to the Financial Ombudsman Service. In July, Mrs Bamford won adjudication in her favour and a cheque for £15,000.

Mr Brashaw's fact-find had assessed Mrs Bamford as medium- to low-risk, but the Lloyds TSB adviser deemed her to be medium risk. Worse, the adviser had not mentioned the income-tax implications to Mrs Bamford: 5 per cent of the 8 per cent return was return of capital, but the remaining 3 per cent was liable to income tax.

But there is a range of funds that can help protect investor capital against the downside of equity markets while not locking investors in for three to six years. These are the funds in the Investment Management Association (IMA) Guaranteed/ Protected Funds sector. These funds can be bought and sold daily like any other fund.

But, as usual, things are not as simple as they seem, because the IMA has included two types of fund in this one sector. Of the 11 funds concerned, six invest in equities, but, employing a technique known as efficient portfolio management, use some investor cash to purchase options to preserve their position with protection provided by an annual price lock-in. But that was for the five years to 31 March, 2003. Since then, the index has perked up by nearly 16 per cent, but over the same period the Close fund returned 1.5 per cent. The Govett fund has risen nearly 4.5 per cent, reflecting its equity content. This shows the downside of protected funds in a rising market.

The Govett fund locks in 98 per cent of growth in each quarter, and four of the Close funds lock in 95 per cent a quarter. But Close UK Escalator 100 locks in 100 per cent of market growth every quarter.

If the Close fund appears too good to be true, the downside of such funds is that you miss out on a varying and unpredictable proportion of growth when markets rise because of the cost of protection. And the higher the level of protection the greater the cost. This cost has risen significantly since the early 1990s because of lower interest rates and the increased cost of options, a result of increased market volatility. Many advisers are sceptical of their value.

Philippa Gee, investments director at the IFA Torquil Clark, says: "If you are worried about the stock market, there is a clear argument for not going into equities. If a five-year return on these funds is 10 per cent, then I would rather have 4 per cent a year from cash, thank you very much."

Patrick Connolly, of the Bath-based adviser Chartwell, says: "We don't like them. You pay too high a price for protection in limiting the upside. With some, you can get a better return on a deposit account. With most, you have protection quarterly. If you choose a lower level of protection, usually 95 per cent, it is possible to lose 20 per cent over 12 months, and the cost of 100 per cent protection is so high you might as well be on deposit."

But when checking actual performance many investors would say 15 per cent over five years is not a bad return from the Close UK Escalator 100 when the FTSE 100 Index has plunged more than 30 per cent and the HSBC index tracking fund is down 33 per cent.

But these statistics form an argument for sticking with trackers if you think the market is rising, but decamping quickly into a protected fund such as Close's when you think it is about to fall, assuming you are clever, in which case you might as well invest directly in the stock market and not bother about protection.