Are guaranteed funds the answer to low interest rates?

In these turbulent times, with interest rates continuing their inexorable slide towards zero and returns from cash on deposit verging on the derisory, it is understandable that investors will look for products that offer certainty and safety.

And few investments look more attractive on the surface than guaranteed funds, which promise stock market returns but with an underlying guarantee of income or return of capital.

These are certainly alternative income opportunities but, like all investments, they have to be meticulously researched and the investor’s attitude to risk, capital protection and capital accessibility all carefully taken into account.

There are number of funds which will offer an attractive rate of income, say between 6% and 8%, which can be tax free within an Isa and that income can be guaranteed for a period of perhaps five years.

The key issue, however, is that the return of the capital after five years will depend on the performance of particular indices, usually including the FTSE 100. In a fund which has just closed, for instance, capital would be returned if the Footsie had not fallen by more than 50% over the period.

History dictates that markets rebound after a recession, so such a fund could be viewed as a reasonable option but the banking and liquidity crisis is steering us into uncharted territory, so the investor’s attitude to risk has to be a key element in any such decision.

The guarantee is usually met through the use of financial instruments, such as options, which offer the potential to protect the overall investment. To pay for the guarantee, investors agree to a cap on the amount they receive in the event of equity markets rising.

This means it is unlikely that guaranteed funds would grow as fast as non-guaranteed funds when the stock market is performing well, so longer-term performance could be disappointing. Charges, which can be significant, must also be taken into account, as well as the dividend return on the underlying share.

There is no doubt that guaranteed funds have a part to play for an investor prepared to take the risk within a well-balanced portfolio, but in no circumstances should they be seen as a panacea for a low-interest rate climate.

Grant Middleton is a Tax Partner in the Edinburgh office of French Duncan LLP, Chartered Accountants