Playing the protection game

Here's the deal: give us your money and we'll give you a return that matches the increase in share prices over the next few years. And if share prices fall, we'll still give back all your money.

That's a typical offer for a "capital-protected" investment.

The return can be linked to a sharemarket index, a collection of indexes, a commodity such as gold, but the basic proposition is the same: gain without pain.

Too good to be true? Not necessarily, but anyone contemplating such a deal needs to ask a few questions.

How do they do it?

The usual approach is for the investment manager to put some of the money into a fixed-interest investment. How much will vary, depending on interest rates, but let's say $60 of every $100 gets used that way.

Over the term of the deal, that $60 grows back to $100, so that by the end there's enough to repay the initial investment.

The rest of the money is used to buy options - in effect, a way of betting on sharemarkets.

If markets rise, those options will be profitable. The bigger the rise, the bigger the profit. That profit is passed back to the investors, plus their original investment.

What does it cost?

Difficult to answer in dollars. There may be an initial fee, but typically there's no management fee because the manager has earned a margin in arranging the deal.

With some capital-protected investments, you get only part of any rise in sharemarkets. In effect, the bit you miss out on is the cost of paying for security.

Another cost: this sort of investment doesn't pay any dividends.

What are the risks?

If circumstances change and you have to withdraw your money early, the protection doesn't apply and you could lose if the markets are down.

Ask who is making the promises. The level of security depends on who is holding the fixed-interest deposit and issuing the options; they need to have a solid credit rating.

And, although your money is protected, the return may not keep up with inflation.

What does the fine print say?

How much of the sharemarket gain do you get - 100 per cent, or more, or less?

Is there a limit on the total return you can earn?

How much protection do you have? It may be total or it may be limited; if share prices fall by more than a certain percentage, for example, protection might not apply. How does tax affect the return?