Wealthy investors can afford to follow the golden rule of equity investment - spreading the risk - but small investors, who may only have one throw of the dice, have to be very discerning. With an expanding range of investment options available, a lump-sum investor needs to start with a little self-analysis. It all comes down to appetite for risk and reward.
The first two months of the year saw the introduction of a plethora of tracker bonds from various financial institutions. These investment vehicles are generally on offer for a number of weeks and investors are locked in for two to five years after the closing date. Tracker bonds are suitable for a certain type of investor. The main selling point of such bonds is the capital guarantee. This means you will get back what you put in.
Several years ago, the capital guarantee was always 100 per cent but, as guarantees are more costly to put in place in a low interest rate environment, 90 per cent guarantees are now common. The difference between investing in a tracker bond and other investment vehicles linked to stock market performance is that all or most of the investment would be secure if the market collapsed during the investment term. This is appealing to cautious investors who want to avoid risk but are prepared to take a chance to outdo the meagre return on a deposit account. So what is the link between tracker bonds and stock market performance and what kind of returns can investors expect? A tracker bond is essentially a fixed-term deposit, where some of the investor's capital is used to buy an option on an index or indices. This is how it usually works: if £100 (#127) is invested, £70 to £75 of that will be put on deposit to mature after, say, five years at £100. That's the capital guarantee taken care of. The remaining portion of the investment is used to buy the options on the chosen indices. This is what produces the return. Tracker bond fund managers do not actually buy the stocks in an index - the option will mirror the performance of the index instead. The advantage of investing in an index is that if one of the stocks in the index collapses, it is removed and replaced by another.
Depending on how the products are structured, the investor will get a percentage or all of the growth of the index during the term of the bond. Some trackers put a ceiling on how much growth is passed on to investors. This is usually related to the level of capital security.
The 4Sight bond from Liberty Asset Management, for example, offers two choices. Investors can opt for 100 per cent capital security with 70 per cent of the growth - that's a maximum profit of 70 per cent.
The other option is a maximum of 100 per cent growth and 90 per cent capital security. Those who are prepared to risk 10 per cent of their capital have the potential of making greater profits, but they also have the potential to make a loss.
Most tracker bonds are based on a five-year term, but Ulster Bank has introduced a new two-year investment, the Euroland. The Euroland provides 90 per cent capital protection after two years, but growth is capped at 30 per cent. If the index put in a stellar performance over the investment timeframe, the Euroland investor would not be breaking open the bubbly, but 30 per cent is still a very respectable return by most standards. On the other hand, if the market was to crash, the investor would lose 10 per cent. As the name suggests, the Euroland bond is linked to the Eurostoxx 50 Index, a popular index for trackers at the moment.
The Eurostoxx 50 Index measures the performance of 50 top companies across European stock exchanges.
Since 1992, the average return over each two-year investment period has been 26.5 per cent gross. Of course, there is no telling whether such a rate of return will be sustained. Returns are subject to an exit tax on encashment. The exit tax rate is the standard tax rate at maturity plus 3 per cent. For the coming tax year, that would be 23 per cent. First Active's first tracker bond of 2001, the Secure Global Bond, follows a slightly different model. It's linked to four indices - the Eurostoxx 50, FTSE 100, Nikkei-225 and the US S&P.
Investors have two options. Instead of capping the potential profit like the 4Sight bond, the Secure Global Bond puts a limit on the percentage of the growth of the indices. The first option allows the investor to participate in 50 per cent gross of the potential growth of the indices over a three-year investment term.
The second option allows the investor to participate in 75 per cent gross of the potential growth of the indices over a five-year term. There is 100 per cent capital security in both cases. The most important date in the life of a tracker bond is the last day of the term. You might have a glorious run for two years, 11 months and 29 days, and then see the stock market take a nasty downward turn at the last minute.
This risk is minimised with what is called an averaging clause. This is a built-in safety mechanism that kicks in six to 12 months before the end of the investment term. The bond will take the average monthly price of each index over the final period in order to calculate the return.
While this feature is designed to protect the investor against any sudden falls in the markets near maturity, it may also reduce returns if there is a sudden upturn near maturity.
Last but not least, what level of charges can an investor expect to pay? The financial institutions typically have a 3 to 4 per cent margin built into the product, which may not be immediately obvious. Investors should ask for charges to be clearly explained.
Tracker bonds are traditionally designed for lump-sum investments, but Irish Nationwide, and possibly others, are considering developing a tracker to suit the new savings scheme announced in the Finance Bill.
