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Beating inflation with minimal risk

If you have savings in the UK, now may be a good time to take a lookat capital-protected investments

28 September 2010

AT ITS August meeting, the Bank of England’s Monetary Policy Committee voted to keep the UK interest rate at 0.5% for the 17th consecutive month.

Low interest rates are falling way behind the current rate of inflation and, as a result, cash on deposit is losing real value.

In addition, despite the fact that rates are low, the current economic circumstances mean that lenders are still reluctant to lend and, as a result, the rates for borrowing, compared to bank base rate, are higher than the long-term average.

The chief economist at the British Chambers of Commerce, David Kern, recently said: "British business will find it difficult to drive a lasting recovery without a prolonged period of low interest rates. Any serious consideration of raising interest rates should be off the table until the second quarter of 2011 at the earliest."

One of the senior economists at Ernst & Young, Peter Spencer, said that, if the UK government goes ahead with all of its proposed spending cuts, interest rates would have to be kept low for longer than markets have anticipated and could remain at 0.5% until the end of 2013.

Roger Bootle, one of the City’s best-known economists, has again warned that "interest rates could stay at 1% or below for several years yet".

Bank of England governor Mervyn King also recently stressed the importance of sustained economic growth and hinted at further stimulus measures. He told a committee of MPs there had been no discussion of "applying the brakes" yet.

So what can savers turn to at this time to try to beat deposit accounts and inflation? Even if you do not need your savings to generate income, these low interest rates and current rates of inflation will mean a significant reduction in your spending power in future years.

It is generally accepted that, over the long term, real assets such as equities or shares provide the best opportunities to outpace inflation. If you do require income from your capital, you could invest in a high-dividend equity fund. Such funds provide both regular income and the potential for capital growth over the medium to longer term.

If you are still wary of direct equity investment, either because you are a lower-risk investor or have enough exposure to equities in your portfolio already, one option is a bond fund.

They also pay regular income, usually higher than a bank account, as well as offering the potential for capital growth over the medium to longer term. Alternatively, income be can accumulated in the fund to further increase capital growth potential if you wish.

Bonds are usually less risky than equities, but capital values can still rise and fall according to prevailing market conditions. The income levels, however, will not necessarily be impacted in the same way – over the recent financial crisis, for example, the income from bonds has held up well.

If you are seeking protection for your capital and do not need income, you could consider a capital-protected investment. Such investments obtain the benefit of rising equity markets but without any risk to the capital invested.

The priority for the risk-averse is to select an investment fund that offers a 100% capital protection over the investment term.

Even if markets fall over the term of your investment, you will not be exposed to any loss of your capital. You will receive your entire investment back at the end of the term (provided you hold it for the full term). If markets rise over the term, the fund will provide a return linked to the improvement in a major world stockmarket index or indices.

Capital-protected funds are therefore an attractive alternative to cash for medium-term investors looking for improved returns above those available from cash on deposit.

These funds can also act as a risk reduction strategy in an investment portfolio. Holding a diversified portfolio always helps to lower risk. Including a 100% capital-protected fund as part of the diversification lowers risk further.

Note that with capital-protected funds you will need to invest for the medium term, over a fixed period, normally five or six years, so such funds are only suitable for capital that you will not need access to for the period of the investment term.

The funds do not normally provide income. You can usually make a withdrawal or cash your investment in early if necessary, but this may affect the amount received and the capital protection, so plan to hold such investments for the full term.

A risk on such an investment is the loss of any bank interest you would have made had you left the money on deposit, but if you expect interest rates to remain low for some years this is not a significant risk.

Also bear in mind that, if equities perform well over the period, the returns are unlikely to be as good as a direct investment into equities – but the capital protection should make this an acceptable compromise for many. You could, of course, invest some capital directly into equity funds and some into a capital-protected account to balance out the risk and reward.

The capital protection is dependent on the guarantor meeting its obligations. You should therefore check out the institution which provides the capital protection. A "too big to fail" bank is likely to be suitable, given they are in effect guaranteed by their respective governments.

There are various types of capital-protected funds available, which, at a glance can appear similar. However, some are riskier than others. Ask a reputable financial adviser to guide you through the various options and establish whether a capital-protected investment fund would be appropriate for your personal objectives.

This column is written by Bill Blevins of Blevins Franks financial advice group (www.blevinsfranks.com), who has written for the Sunday Times on overseas finance for the past 10 years. He is the
co-author of the Blevins Franks Guide to Living in France. This column is exclusive to Connexion.

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