Any ordinary investment in shares has the following risks:
- Risk of capital loss (shares sold for less than you bought them for)
- Risk of income reduction (dividend income slashed by the company)
This makes buying shares particularly unsuitable for short-term savings. It’s easy to picture a scenario where a saver puts away £100 per month into a stocks & shares ISA and after 12 months of saving only has £900 of shares leftover.
So, is it possible to invest in shares risk-free? In this article, we’ll look at the financial products created to reduce the risks of investing. We’ll assess one-by-one whether they successfully reduce or eliminate the risk of equities as an asset class. Should they work in theory? Do they work in reality? Let’s find out.
- Structured products
- With profits funds
- Hedge funds
- Absolute returns funds
- Cautious actively managed funds
- Dollar-cost averaging
- Short ETFs
- Free share sign-up offers
Structured products or structured investments are complex packages of bonds and derivatives that aim to pay investors a return that is linked to the stock market. In particular, the movement of stock market indexes such as the FTSE 100.
It’s not a direct investment in shares, but a contract with a financial institution who promise to pay you a return. This return is calculated based on various rules, the primary rule usually is that the stock market must remain at or above a specific index level on the anniversary dates of the investment for it to produce a positive return.
Our guide to structured products provides several detailed examples of real structured products to help you understand them better.
These products effectively ‘cap’ your returns, because if the stock market doubled overnight, they would only payout the pre-agreed rate of return, e.g. 10%. However they have strange behaviour. In the example above, if the product ended its term only 1% above the starting index level, you’d still earn 10%. So the returns from a structured product can exceed the actual stock market in certain circumstances.
Structured products belong in this list of risk-management products because they frequently offer to protect the capital of the investor… up to a point.
To illustrate, the ‘Tempo FTSE 100 EWFD Long Growth & Kick-Out Plan: October 2021’ which was available for investment at the time of writing, has a ‘barrier level of 60%’. What this means is that so long as the relevant index doesn’t fall below 60% by the index measurement date, the investor is promised to be paid back their original capital.
Are structured products risk-free?
Structured products aren’t completely risk-free because they still contain risk of loss in the following circumstances:
- The index falls below the capital protection barrier level by the measure date
- The financial institution that backs the financial obligations of the scheme collapses
Structured products are also volatile. One day, you could be on track to receive a 30% total return for a multi-year investment. The next day, thanks to the index falling below its starting level, you may now be owed a 0% return. This wouldn’t be a loss of your original investment, but it would feel like a loss relative to your expectations.
You could also include the risk of underperforming the broader market in the scenario where the stock market rises by more than the promised return of the product. This is an opportunity cost rather than an investment loss.
So in summary, structured products still contain volatile returns and potential downside risk. However, those risks and rewards have a fundamentally different ‘profile’ to ordinary share investments, and some investors may prefer a cap on their return in exchange for some capital protection. The best structured products books don’t suggest that this investment is a replacement for stock market investing, but rather it could be a useful addition to a stock market portfolio to enhance returns in a number of scenarios.
A ‘with-profit fund is a mutual fund contained within a second account ‘wrapper’. The underlying mutual fund (or funds) invest directly in equities and other investments such as corporate bonds. The proceeds are paid, not to you, but into the second layer of account wrapped around the fund.
Within this wrapper, the with-profit fund managers decide how much of the years gains to reflect in the fund price, and how much to ‘hold back’ for a rainy day.
As an investor, you will only see appreciation in your fund unit value to the extent that the with-profits fund managers allocated that profit to the unit price. This is sometimes referred to as an ‘annual bonus’ or similar, to make clear that the unit price isn’t a market value.
In periods of poor performance, the underlying fund may underperform or fall in value. The fund managers then have the discretion to use some of the held back profits to support the unit price of the fund held by investors.
Are with-profits funds risk-free?
This smoothing of the financial returns gives the appearance of a less risky investment.
However, all that is really happening is that early good news is being hidden from view, only to be released during a period of bad news. A with-profits fund usually never exceeds the value of the underlying fund at any point. Therefore, the with-profits investor will never ‘lose’ less than an investor owning the underlying fund directly.
Therefore, while the experience of owning a with-profits fund might feel less risky. You are not really being protected from the underlying risks of investing in equities.
Of course, with-profits funds do vary and we’re describing one type of with-profits fund. Not all will operate in this specific way. Some with-profits funds protect against losses, however, the trade-off will be that annual returns will be significantly less than the underlying fund. At this stage, it’s difficult to compare that investment to a real stock market investment.
Hedge funds are sometimes able to make profits in a downturn. This is because hedge funds rarely take a view on the direction of the stock market as a whole. (If you wanted this you could have picked a cheap equity ETF).
Their diverse and advanced investment and trading strategies are often credited for price behaviour that is ‘uncorrelated’ with the stock market. They simultaneously go long on some instruments and short on others. This reduces their overall exposure to ups and downs in the broader stock market.
Are hedge funds risk-free?
However, as we explain in our guide on how to invest in hedge funds, the promise of uncorrelated returns isn’t the same thing as risk-free returns.
If the stock market returns in three years are: 2%, 12%, (-4%) and a hedge fund returned: (-5%), 3%, 43%. That’s an uncorrelated return. I.e. there appears to be no linkage between the two. It’s clearly not the same thing as a risk-free return, as hedge funds are actually riskier than the stock market as a whole and produce dramatic profits as well as losses. It’s difficult to pick the best funds to invest in using historical information alone.
Absolute return funds
Absolute return funds follow a portfolio management strategy that sees it allocate to asset classes which will reduce the overall volatility of the fund, particularly in a market crash. The objective is to try and keep the performance of the fund above 0% in all periods.
For example, an absolute return fund may invest in an asset class that tends to surge during a downturn, such as:
- High-quality government bonds
- Save haven currencies
- Defensive shares (companies that are unaffected by recessions, e.g. water companies)
- Counter-cyclical shares (companies which perform well during recessions)
These won’t necessarily be the mainstay of the portfolio but will be present in sufficient quantity, in theory, to reduce losses in turbulent conditions.
Are absolute return funds risk-free?
In practice, however, the track record of absolute return funds has not been excellent. Many have unfortunately failed to deliver on their golden promise of keeping returns above 0%. Our main article linked above shows some real examples.
Cautiously managed equity funds
Similar to absolute return funds, cautious funds follow an investment portfolio approach that is focused on volatility.
However, rather than focusing on counter-cyclical assets, it looks for equities with lower volatility and uses asset allocation weightings to boost lower-risk sub-asset classes within equities (e.g. large cap over small-cap).
Finance books which include the Capital Asset Pricing Model (CAPM) will explain that where an investment manager seeks out assets with lower volatility (beta), they will inadvertently lower their expected return. This is because the market adjusts prices in such a way to offer higher returns for investors who take a greater risk. This works against a cautious fund manager.
Are cautiously managed equity funds risk-free?
As a mutual fund that holds equities, cautiously managed funds are not risk-free. The word ‘cautious’ refers to only a subtle distinction in strategy. It’s largely marketed in this way to appeal to conservative investors.
These specialist and high-risk funds produce gains when the reference index falls. A short x 2 ETF will aim to deliver a daily return of 2% if the stock market fell by 1% on that day.
While these do protect investors from a loss on a ‘down day’, the inverse is true when the stock market performs well. As the stock market is expected to rise over the long term, this makes short ETFs an unnecessary and unwise addition to a stock market portfolio.
When held alongside share, they will simply ‘cancel out’ the returns from your shares.
Furthermore, short ETFs don’t perfectly replicate the inverse of the market. They’re designed to be held for very short periods rather than over the course of a year. This is due to the nature of the derivatives which allow them to produce the returns they do.
Are short ETFs risk-free?
As a stand-alone investment, short ETFs and leveraged short ETFs are probably riskier than a normal equity fund.
Dollar-cost averaging is the soothing effect of drip-feeding money into a volatile market like the stock market over a long period of time.
Some money will be invested at relative high asset prices, and some will purchase shares at a bargain price. Overall, the average investment cost should be somewhere in the middle of the range of prices over the period.
On paper, this reduces the risk of investing, in the sense that by aiming for a ‘middle-of-the-road’ purchase price, you will avoid the worst-case scenario of investing all of your money at the top of the market.
Similar to structured products, this is another approach where you deliberately exclude yourself from the possibility of scoring top-notch returns, but in exchange, you are also protecting yourself from some downside risk.
If you have a large lump sum of cash and you plan to dollar-cost average over three years, you will have to consider the lost returns from keeping so much of your cash ‘on the bench’ whilst you slowly drip feed the amount into the market. For this reason, it’s more effective overall over shorter periods e.g. 1 – 2 year rather than 5 – 10 years.
It’s popular because many of us do this without thinking. Any workers with a defined contribution pension scheme or a regular direct debit that tops up our UK stockbroker account each month are already dollar-cost averaging.
If you want to invest without risk to your original capital, one way you can do this is by investing nothing to acquire those shares in the first place.
Our guide to how you can earn free shares will point out the many offers available to those who sign up to investing apps. Many of these offers result in the award of a free share or free shares to new users.
Conclusion: is it possible to invest in shares risk-free?
Overall, it will now be clear to you that any investment produce which contains ‘stock market’ returns will contain risk. To actually obtain stock market returns, you must be invested in the stock market. If you don’t have a direct investment, then your financial institution will have to invest on your behalf. So long as someone is investing, then the risk is being borne. Ask yourself, why would a financial institution agree to take all of the risks themselves if you are the ones getting the returns?
This is why you should be sceptical when you learn about ‘risk-free’ or ‘low risk’ stock market investments. If any risk is being taken away, then it’s likely that some return is being held back too (to reward the party who will take the risk).
It’s a theory that is universal because no business that wants to make money will ever take risks without being compensated for them.