by W.A. Steer PhD
A little over two years ago, the tied Financial Advisor at my bank tried (and fortunately failed) to talk me into buying a Guaranteed Investment Bond. This
was a 'financial product' offering returns 'linked' to the stock-market, but with a guarantee
that I wouldn't lose my capital in the event of the stock-market suffering heavy losses. During the meeting I
realised that the implications of the small-print were not straightforward, and my subsequent inquiries and
analysis revealed that this was a shockingly bad buy. Statistically I'd be much better off keeping my money
in a savings account with a good interest rate. Similar products are widely criticised, and on this page I reveal
how some mathematical sleight of hand can be used to ensure that the odds on this gambling device are stacked very
heavily in favour of the bank.
Marketed directly to the consumer and novice-investor, products such as the Guaranteed Equity Bond (GEB), Guaranteed Investment Account,
Guaranteed Investment Plan and other similarly-named offerings typically promise implicitly-high returns
'linked' to the stock-market, but with a degree of protection for your capital should the worst happen. They are normally
5-year fixed-period investments. Rather than investing directly in the stock market, these products (personally I'd
prefer to use the word 'schemes') offer returns based on some algorithm which measures the stock-market index
(typically the FTSE-100 or the FTSE All-Share, in the UK) in some way at the start, end, and/or during the term of the
bond. The terms (algorithm) can be deceptively simple but frequently hides some nasty devils in the details. In financial
language, these type of bonds are examples of 'structured products'.
Drawbacks (the obvious ones)
There are several fairly common catches, which you should have your attention drawn to by your 'advisor', and
are also mentioned in commentary in the financial columns in the press. They include:
- Fixed 5-year term - there are normally heavy penalties for dropping out early. You can't call 'top' after a market surge, nor bail out if the market nosedives.
- Dividends - you don't receive dividends that you might get from the shares if you'd invested more directly (eg in a unit trust/tracker)
- Entry/exit/annual-management charges - beware charges sometimes imposed which reduce the value of your investment
- Tax - sometimes the tax position is less favourable than direct investment (check the small print)
- Guarantee - try to visualise the guarantee against the returns from a good savings account. Invariably it still represents a loss after inflation.
- Limits on the gains - for example '75% of the rise', or capped to (say) 40% over the term, and/or sometimes much more subtle tricks...
It is often used as a rule-of-thumb that over the long term, the FTSE rises at 7% per year. That's 40% over 5 years due to compounding.
Effect of compound-interest, or compounded market-growth, over 5 years.
|Annual rate: ||2.0% ||4.0% ||4.5%|| 5.0%|| 5.5% ||6.0% ||7.0% ||8.0%||10.0%||12.0%|
Obviously, since the performance of the investment depends on that of stock-market index to which it is linked,
there is no certain way of predicting what the returns will be. For products with fairly simple rules, it's not
difficult to make a guess as to the likely outcome, given some assumptions about how the market will perform...
but it is essential to understand the implications of the small-print.
Short-term stock-market fluctuations
As well as a long-term (hopefully-rising) trend, any stock-market exhibits fluctuations across many different timescales. There may be 'surges' lasting
several months, periods of stagnation, the occasional abrupt fall, and daily essentially-random variation. It the latter
which is most easily overlooked, yet can have significant implications for these schemes. The FTSE All-Share index, for example,
typically varies from its monthly-average by ±1% to ±1.5% over a few days. There can also be other relatively short-term
shocks lasting a few weeks.
Mathematical sleight-of-hand no.1: using index-averaging to shorten the effective term
Clearly you'd be gutted if, on the last day of your bond, the market took an abrupt downward turn, and lost several percent...?
So one solution the bank may offer (read the small print) is to take into account an average value of the market over
some period of time. This may be one month, but several offers I've seen recently average the index over a whole of the first
year, and again over the whole of the final year, to determine the 'initial' and 'final' values of the index from which your
returns are calculated. Think about that. What they are doing is using the average value of the index six-months into
the term, and six-months before the end of the term. For a product with a five-year term, you are only exposed to the
benefit of FOUR years of stockmarket growth! Assuming the stock market rose at a steady 7% per annum, using this
method the banks' calculation of the index growth would only be 31% over the term (5.6% per year) rather than the 40% rise in
the index. Sneaky!
Mathematical sleight-of-hand no.2: conveniently ignoring compounding of interest
Some products have more complicated rules, which opens up all sorts of new games for the banks to play. For example: as the
bank I offer you a 5-year product which I break down into ten 6-month periods. I measure the rise or fall of the index in
each period, 'clip' that gain or loss to a maximum of ±4% within the period (ignore this distraction for the moment), then determine
the final value of your investment by adding together the percentage gains or losses for the ten periods. Being generous(!) I might
also offer some further overall guarantee on your capital. Did you miss that? A small word that: 'adding' as in
'...by adding together the gains or losses...'. This means they're not compounding the gains as would happen if
you'd made a direct investment in the market, and your returns will be less. As an example, going back to the simple
assumption of smooth 7% annual growth (40% over five years), equivalent to 3.44% per six-months, by adding the gains rather than compounding them, the bank manages to
calculate your return as 34.4% (10× 3.44%, equates to 6.1% per year) rather than the 40% gain of the index. Again
Mathematical sleight-of-hand no.3: using uneven index growth in conjunction with short-term 'clips' to limit gains
Return to my enticing offer of the bond with the six-month periods. See how I offered to clip your losses to no more
than 4% per period. Is that reassuring? I also clipped your gains to 4% per period. However, if the typical return
of the index is 7% per year (3.44% per six months), the index only has to rise fractionally above its long term trend
before that limit begins to come into force. Meanwhile the index would have to fall 7.44% below trend before the
negative cap was any benefit to you, my customer. As the index does not increase smoothly, but goes in fits and starts,
that upside limit cuts in remarkably often. The index might go up 7% in six-months then stagnate for the next six-months;
in that case I only give you 4% for the year. In fact even if the index were to rise fairly smoothly overall, the day-to-day
random fluctuations of a couple of a percent could easily cause that upper limit to cut in. The only way to gauge the
likely impact of these kind of rules is by running them through historical stock-market data using a spreadsheet or
dedicated computer program. Needless to say, this 'six-month/±4% cap' type of scheme gives atrocious performance.
This is approximately the scheme I was offered by one of the 'big five' British banks, and on analysis really shook me.
I was amazed that our usually-strict British financial regulators haven't clamped down on the practice. It's very very sneaky!
Tranches / Issues
A given provider of GEBs typically tinkers with the terms (algorithm) on offer every six months or so, and each new
version gives rise to a limited-release of bonds known as an 'issue' or 'tranche'. This also means (conveniently for them)
that any detailed analysis anyone does on a specific algorithm is soon out-of-date.
I'd been brought up to have a healthy cynicism about banks, but this particular episode opened my eyes to a much
murkier world, right on our high-street, than I'd ever expected.
I'm not saying that all GEBs are necessarily bad; there may be some available for which the price paid for the
reduced risk compared to a direct stock-market investment is fair. But from what I've seen, you need to
look extremely closely at the fine print, perhaps pester the institution for important details which aren't even stipulated
in the publicity brouchures, and fully understand all the consequent implications. It appears to me that too often
a simple savings account with a top-rate of interest is statistically provable a much better investment. If interest
rates rise further, this is even more true.
The following articles on British personal-finance websites offer criticism with a similar sentiment, though less detail
on the precise nature of the catches:
I am not a qualified financial advisor. I am educated in physics, and apply data-analysis skills across disciplines
as I see fit. This page is meant to be an eye-opener; it should not be construed as financial advice. The value of
investments can go down as well as up. Etc. If there's anything on this page you don't understand then you really
need to talk to an independent financial advisor before making the decision to purchase (or not purchase)
Created: February 2007
Last modified: 5 February 2007 [I intend to add a few graphs/illustrations shortly]
©2007 William Andrew Steer