Some tracker bonds fail to keep the pace

Is the gloss going off tracker bonds? Two more trackers have just been launched by Ulster Bank and the stockbrokers MMI, but more attention is also being paid to the downsides of these investments - tying up capital for a strict three-to-six year period, the inflexible nature of the options purchased and the increasingly longer `averaging' period on returns being adopted by some bond manufacturers.

In a report by Mr Niall P Doherty of the independent financial advisers, Asset Management Trust, it is claimed that opting for a tracker bond for access to stockmarket growth rather than investment funds or even direct stock picking "could cost investors almost 50 per cent in capital growth".

He points out that the big selling point of trackers - the capital is fully guaranteed - is now being eroded by some bonds, such as the latest BCP and MMI ones which only guarantee 90 per cent of capital. Trackers also involve an unsuitably long investment period for many people and reflect the capital rise only of selected indices but not dividend income. In the case of one five-year nine-month tracker, this amounted to the foregoing of 15 per cent worth of growth, says Mr Doherty.

The fact that trackers are not exposed to currency risk is no longer a plus point either: "Against the current economic background, with the pound facing further weakness in the run-up to EMU in the short term and a potentially weak euro in the longer term, the lack of exposure to currency movement is a clear negative. It is widely expected that Irish investors, with international exposure will make currency gains in the medium-term."

The restricted nature of the indices selected by most tracker bond managers - mainly bluechip at the automatic expense of some of the surging smaller indices - could also be seen as a downside, according to this report. Another is the passive management of the indices and the longer averaging of returns.

The averaging clauses should be of particular concern, says Mr Doherty. "This feature is often marketed as one of the key benefits of tracker bonds," he says. However, by using a period of months towards the end of the investment period during which the returns are "averaged" out to lessen the effect of any sudden drop in the market, there can be a "considerably negative impact upon investor funds, in addition to the protection which the feature may offer", he says.

"If one considers that the underlying premise of tracker bond investment (and indeed all stockmarket investment) is that markets tend upwards, it is likely that the averaging feature of tracker bonds will have a detrimental effect."

In the case of one bond in which the averaging clause amounted to 21 months the retrospective impact, using the past five years and nine months (to October 1997) as a gauge, the effect was reduced capital growth of 25 per cent on the actual performance of the market indices. In the case of a three-year and 10-months tracker with two averaging periods of the first six months and the last 18 months, the total reduction of capital growth was 20 per cent.

Asset Management Trust's clinical analysis of the downsides of trackers may be missing the point of such investments for many small investors. Trackers are cheap to buy into, they are relatively simple to understand, there are no obvious high entry costs (though costs are certainly built into the pricing of this product), the vast majority of bonds continue to guarantee capital as long as there are no early encashments and, so far, net annual returns upon maturity have been quite good (in the 10 per cent region).

The increasingly long averaging clauses could very well spell the end of trackers as one of the preferred investment options for people with smaller sums. Certainly anyone buying one today should look very carefully at this clause and think about avoiding those with averaging period of more than six months if they want to maximise potential growth.