Jonathan Davis: All that's guaranteed is worry

It is encouraging to see the Financial Services Authority has finally begun to grasp the nettle of misleading financial advertising. This week it fined DBS Financial Management, a chain of financial advisers, £100,000 for a supplement singing the virtues of "protected Isas" sent to millions of newspaper readers in the summer of 2001. This supplement, Carol Sergeant of the FSA found, was approved by someone at DBS who was not qualified for the job and "was unfamiliar with the product". She said the brochure "did not come close" to being "clear, fair and not misleading", as the FSA requires.

Of course, advertising is an important element of the marketing mix used to sell financial products, and nobody should be surprised to see the finer arts of copywriting applied to make them sound more enticing. The principle of caveat emptor must also apply. But there is no justification for providers or intermediaries creating a fundamentally misleading impression of what they are selling, which does happen, deliberately, in some cases (as the file of dodgy product brochures I like to keep testifies).

As in this case, some modern-day financial products can be extraordinarily complicated for anyone not familiar with the derivatives market. It takes a lot of detective work to plough your way through the details to find out exactly what sort of animal you are being asked to buy. Even then, the risks may not be immediately apparent. I am not convinced many financial advisers always understand what they are pushing at their clients.

The "protected" or guaranteed bonds popular in the past few years are particularly dangerous for those who lack the sophistication to understand them. These investments usually try to link investors' returns to movements in the FTSE index (or equivalent) and also often purport to "guarantee" your capital. These types of product use derivatives (futures or options contracts) to cover the provider against a range of eventual outcomes: from the provider's perspective, the return is often locked in at the outset, which is why they have become popular.

Some of these products do offer investors a risk-reward trade-off that may be attractive. But it is also fair to say the probabilities of different outcomes are hard to assess accurately even if you have the necessary computer-modelling power. By definition, these products are also hard to describe accurately in words the average retail investor is likely to be able to understand: it is no surprise if the copywriters don't always understand what they are describing. In three years, of the many brochures for products of this kind I have seen, I can safely say I have seen few that "clearly and fairly" explain their true nature. I would not say most are fundamentally misleading, but not many give a comprehensively balanced picture. It does not surprise me investors found that what they were buying was not what they thought.

The worst cases are so-called "precipice bonds" which offer investors what sounds like an impressive array of benefits. They are, a return linked to the movement of the market as a whole and a guaranteed return of capital except in certain circumstances that sound impressively remote, such as a 50 per cent decline in the overall market between certain dates. The drawback to these precipice bonds is that if the improbable-sounding circumstances do arise, after the threshold has been breached, the potential loss of capital increases dramatically.

The steeper the fall in the relevant market, the greater the capital loss. In some cases, investors who bought these products in the days when the stock market was flying high stand to lose 80 per cent or more of their money. There are many tricks the designers of these products use to make what they are offering appear more attractive than they actually are. The protected Isa that prompted the FSA fine seems to have used more than one of these.

For example, the advertising supplement described the product as having "no initial charge", when this was not true. In fact, the combined effect of initial and annual charges added up to a reduction in yield of 4.8 per cent per annum, a substantial price to pay for the so-called protection the product was said to offer.

Another common trick promoters get up to is to refer returns being linked to movements in the market, when a closer inspection reveals that what drives the product's return is not the change in the market over a given period, but the average movement recorded during different parts of that period. The effect of that is to reduce the extent to which the investor shares in any gains the market might make.

The reason you can be sure precipice bonds are being mis-sold – or at least bought ill-advisedly – is that there are few investors for whom the particular combination of risk and reward on offer could conceivably be what they would take on by choice. If you buy a protected or guaranteed bond, you have shown already that you are worried by loss of capital and the prospect of the market falling. The idea that if the market falls by, say, 60 per cent, you would be happy to lose 80 per cent of your money is too implausible to be true. Who in their right mind would want to take such a position?

The only people, in fact, who can rationally want to buy such products are either out-and-out gamblers or those who think they can judge the likely future behaviour of the markets more accurately than the market itself. As there is a derivatives contract standing behind every one of these products, you are betting that the professional who is on the other side of the bargain is not as smart as you are at calling the odds. This may be true, but the odds against it being true are high.

You also have to be aware of the fact that what advertisements sometimes call "guaranteed" return of capital is not always what it seems. In some cases, what you may get back is a combination of the income the investments have earned over the life of the product, plus a fraction of your capital. These two components add up to the amount you originally invested, but that is not the same as saying your capital is guaranteed. This is the flip side of the high-income bonds that offer you a higher-than-market yield, something that can be achieved only by putting a proportion of the capital at risk.

davisbiz@aol.com