Psst! Want a worthless guarantee?

These lousy products are still selling like hot cakes despite offering astonishingly poor value for money. Banks and building societies love them because they're a 'no-brain' sale.

Guaranteed Equity Bonds look attractive at first glance. What, invest in the stock market but get a guarantee you can't lose money and also get gains if the market rises? And all you have to do is commit the money for five years. It's a no-brainer sale for the promoter, and a no-brainer buy for the investor.

But these products prove beyond a shadow of a doubt that you should never buy an investment product unless you engage your brain and understand it. As the great US fund manager Peter Lynch once said: 'Never invest in any idea you can't illustrate with a crayon'. Even their inventors would struggle to do that with GEBs.

But I will try to explain why these products - despite being sold by Barclays, Legal & General, Bristol & West, NSI and a host of high street names - are bad value and you shouldn't buy them.

Under the bonnet

A typical GEB works like this: commit your money for five years - you can only get it back earlier if you die. At the end of the term, you get your capital back if the stock market index (the FTSE 100 Index) is at or below its original level. If the index is above that level, you get the same percentage increase in your capital. So if the index is up 10% and you invested £10,000, you get £11,000 back.

There are many variations on the theme, more on which later, but let's stick with the simple basic idea—which is pretty much what National Savings & Investments offers. The first key point is that what you get with a GEB is a return linked to the capital value of the index. But if you invested in the same shares that are in the index, or in any fund investing in those shares, you would get dividends. Right now the average yield on the FTSE 100 is 3%, and dividends are rising pretty fast - but let's be conservative and assume that they rise by an average 5% a year over a five-year term.

Then if you put £1,000 in an index-tracking fund whose price never changes over five years, the reinvestment of those dividends in more units in the fund means you will end up with an investment worth £1,176 - you will have made a return of 17.6% just from the dividends.

So to offer the true equivalent of a risk-free tracker, a GEB would have to guarantee you a minimum return of 17.6% over five years, not just a return of your capital and a return linked to the index.

Averaging can really hurt

But GEBs don't really offer the gain from the index, because almost all of them average the index over the last 12 months. They say that they do this to avoid the risk of a last-minute fall in the index damaging your investment. This isn't true. Over any period from one month to 100 years, there is a greater chance of the index rising than falling, and that means that averaging is more likely to reduce your return than to save you from a decline. But what averaging does do is to reduce the cost of buying the insurance against a decline, thus boosting the promoters' profits.

Over the past 12 months the FTSE 100 Index is up about 24%, but using the averaging methods of most of GEBs the gain over this period would have been under half of that.

So in these two respects GEBs take away significant slices of the returns earned on normal stock market investments. The question is, does the no-loss guarantee compensate you for that?

Less risky than it looks

To answer that, let's assume you have £10,000. You divide it in two. £5,000 goes into a five-year fixed rate bond paying 5%. The bond will mature with a value of £6,416. £5,000 goes into an index-tracking fund. We'll assume that because of the dividends it earns, the price of the fund can fall by 15% before you actually lose money over five years. Say it does that - so your £5,000 has fallen to £4,250. Overall, though, your £10,000 has become £10,666. In fact, the price of the tracker fund has to fall by 28% before your total capital ends up at under £10,000 at the end of five years.

How likely is that? The Barclays Equity-Gilt Study shows that of 41 five-year December-to-December periods since 1959, eight of them showed losses of over 28% - about one in five. But six of those periods were bunched together between 1968 and 1972. These figures don't correspond to those quoted by GEB providers because the Barclays figures are in real terms, i.e. adjusted for inflation, and in nominal pound-note terms loss-making periods of over 25% would have been halved.

Wait and get a recovery

And that isn't the end of the story, because periods of sharp loss in the stock market are often followed by periods of sharp gain - as in 2003, when the FTSE 100 rebounded from an exceptionally severe three-year fall of 45% with a gain of 25% and followed that with a gain of 10% in 2004. So if you hold a tracker fund you can just wait for a recovery - while with a GEB you may come out with your capital intact and miss the following gains.

All this strongly suggests that the price you pay for no-loss insurance with a GEB is far higher than it is worth paying, provided you are prepared to add a year or two to your investment period if at the end of the original five-year term the market is down.

Big bear markets like 2000-2003 are once-in-a-generation events - the last was in 1972-74. Smaller, shorter-term upsets when shares fall by 10% or 15% over a year and then recover, are something you should just take in your stride. If you want higher returns than you get from fixed-rate bonds but don't like risk, consider commercial property funds and cautious managed funds. While both can go down, they are far less volatile than shares.

Bring on the baffle-o-meter

Promoters of GEBs are pushing out into new areas. Recently we've seen GEBs linked to baskets of share indices and to commodity prices or commodity indices. Some of these offer a variant where instead of 100% capital protection, you get just 80% protection but instead of 100% of the index gain you get 200% of the index gain.

This shows what GEBs are really all about: they are a kind of betting in which the promoters are the bookmakers. Guess what: the bookies know a lot more about the form and the odds than you do - so should you be surprised that they make more money than the punters?

Some bad current offers

Bristol & West Minimum Return Bond Mini-Cash ISA

This guarantees a minimum return of 15% at maturity at the end of five years, equivalent to an annual return of 2.8%.

Barclays 6-year Minimum Return Plan Issue 16

Over six years, you get a minimum return of 21.5% which works out at 3.3% annually. If the index is up more than 43%, you get a return of half the gain in the index.

Abbey Capital Guaranteed UK Equity Bond

Over five years you get a return of 130% of the gain in the FTSE 100 index, but this is capped at a maximum return of 50%.

Most of the GEBs sold on the high street are likely to generate low returns of a few percent a year on top of deposit rates. If you want more, put some of your capital into safe fixed-rate investments. Many of these have the capacity to make handsome gains even if share prices in general show little change.

By Chris Gilchrist