These funds are safe and now they're sexy

Simon Hildrey charts the rise of capital-protected investments

You can trust the UK financial services industry to spot a new sales pitch. Products known as "capital protected" investments - those that aim to give you your money back as well as a percentage of any stock market surge - are being marketed as offering their best potential for six years.

You can trust the UK financial services industry to spot a new sales pitch. Products known as "capital protected" investments - those that aim to give you your money back as well as a percentage of any stock market surge - are being marketed as offering their best potential for six years.

While their philosophy is simple, capital-protected products are not. They use a mix of cash and complex financial instruments to grow your investment. This usually involves exposing your money to a market index - the FTSE 250, say - while investing in derivatives such as options to hedge against any steep falls.

That they are now being marketed so strongly is due to the decreased stock market volatility. As a result, the cost of options has fallen, which means more of your cash can be invested in the index to generate higher returns. A typical product with a fixed term of six years used to offer you all of your capital back at maturity and 70 per cent of any growth in the linked market index. Now you are more likely to be offered 100 per cent of any index growth - or even be guaranteed a particular percentage growth over a fixed period.

However, even though more of your cash is now exposed to a stable underlying index, there remains the trade-off that while some of the investment is hedged, there is less chance of a dramatic surge in returns.

Companies backing such schemes include HSBC and asset manager Premier. There is no income to be paid and, as long as you don't pull your investment out before maturity, they guarantee to return your initial capital over a fixed term.

Neil Lovatt, the director of marketing development at Scottish Life International, which provides capital-protected products, says that they have a place as part of your portfolio.

"It is certainly a great time to market capital-protected funds but don't be persuaded to buy them because people say they are cheap at the moment." Too much reliance on them and you could miss out on more spectacular growth. "Remember that a lot of nothing can be worse than something of a lot.

"If you want to buy fixed-term, 100 per cent protected funds that enable you to sleep at night, it does not matter when you buy."

It's also worth remembering that protected funds do not receive dividends, so you could underperform the market.

In recent months, new twists on the capital-protected product have appeared. These include a fund from Dawney Day Quantum linked to the FTSE Xinhua China 25 index and another, marketed by Key Data, that says it will give both capital protection and positive returns - even if the market falls.

Ian Lowes, the managing director of independent financial adviser (IFA) Lowes Financial Management, says investors should check the tax implications of protected products as some won't treat the rise in value of your capital at maturity as liable for capital gains tax.

"National Savings and Investments is offering a five-year protected fund that is deposit based and linked to the FTSE 100," he explains. "It is offering a guaranteed return of 110 per cent but the proceeds at maturity will be treated as income rather than capital gains and taxed appropriately.

"This may turn a non-taxpayer into a taxpayer and a basic-rate taxpayer into a top-rate one. "Most importantly, those over 65 may lose their [higher] personal income tax allowance because of it."

As well as racier protected products linked to Chinese indices, another development has been the appearance of "open-ended" capital-protected funds. These more flexible plans let you exit at any point during a five-year term, say, thanks to what is known as constant proportion portfolio insurance (CPPI).

This type of fund, provided by firms such as Zurich and Friends Provident, determines the proportion of assets it needs in cash to make sure it can meet the promised level of protection at the product's maturity.

When investors first hand over their cash, the fund can invest all the assets in the stock market. If shares slumped, however, everything could be switched back into cash to meet the guarantee.

Supporters of CPPI argue that this approach is more cost-effective as investors only need to pay for capital protection when it is required. But critics say that if funds are forced to retreat into cash, there is a risk of missing out on a market surge.

However, since open-ended fund investors are not locked in, they can take what is left of their capital and go elsewhere - usually with no exit charge.