Question Of The Week: Are Child Trust Funds A Good Investment?

As more and more Fools pose their tricky financial teasers on our Q&A forum, here's Jane Baker's answer to the top question this week.

In last Friday's Question of the Week article I looked at pensions for the over fifties. So this week I want to go right to other end of the spectrum and talk about investments for children.

Thanks go to Fool229479135 for this week's Q&A question:

Are Child Trust Funds a good investment?

Fool229479135 asks:

"... Child trust funds are recommended as a good way of saving tax. My grandson was born in September 2002 and so received £250 from the government, later increased to £500 as his parents were on low incomes. As of today, this £500 is now worth approximately £420. How can this be considered a good investment, tax benefits or not?"

This is probably a worry for many parents -- and grandparents -- who are seeing the value of child trust funds drop as the stock market weakens. But before we look at whether this should be a cause for concern, read this article for a recap on how child trust funds (CTFs) work.

Three choices

When it comes to investing a child's CTF voucher, parents will be faced with three choices.

Option #1: The money can be put in a cash CTF where it will earn interest tax-free rather like a Cash ISA does for adults. 

Option #2: You could choose a stakeholder CTF where the money will be invested in shares until the child reaches 13. After this time the accumulated fund will be gradually moved into lower risk assets so that the entire fund is held in cash when the child reaches 18. By using this strategy -- known as lifestyling -- the fund is protected from a sudden stock market crash as it nears maturity.

Option #3: You can fully invest the CTF in shares for the full 18-year investment period.

I don't know whether Fool229479135's grandson has a stakeholder CTF or a share-based CTF, but given the drop in the fund's value, it will certainly have some exposure to the stock market. Arguably, shares are the best place to be invested for achieving capital growth over the longer-term, but I can understand why a CTF which appears to be performing poorly now is causing Fool229479135 a headache.

Saveaholic posts:

"The value of investments fluctuates. It's very easy to panic during the troughs. There's plenty of time yet for your grandson's fund to recover and do well. If you can find the money to add to the fund now (while shares are low in price), you stand a good chance of making the most of any future market recovery. A steady drip feed into the fund (e.g. monthly) is a pretty good way of doing this.

Your grandson won't be cashing in his trust fund for another 12 years. So the value of his fund today is pretty irrelevant. If anyone can afford not to worry about the state of their investments at the moment, it's him!"

(Read Saveaholic's full response and others here.)

I think Saveaholic's post sums it up perfectly. There's no doubt the stock market has had a rough ride lately. But this gives a great opportunity to buy more shares when prices are low if that's what Fool229479135 decides to do on behalf of his/her grandson. CTFs can be topped up by an additional £1,200 each year. If it's affordable, this is a good way to build up a bigger lump sum by the time he reaches 18.

The CTF will then achieve a great boost to its value if -- and hopefully when -- share prices recover. With 12 years left until the CTF matures, that should provide enough time to recoup its value, and provide some capital growth. But, of course, there are no guarantees this will happen.

What about Cash CTFs?

If Fool229479135 is really uncomfortable with a share-based CTF, he/she could think about moving the fund into a cash CTF instead where there will be no risk to the capital. (Although transfers must be made by the registered contact for the CTF -- usually a parent.)

But returns on cash CTFs have suffered lately too. The recent cuts to the Bank of England base rate have forced the interest rates on many savings accounts south. This is true of cash CTFs too with the most competitive offering rates of less than 5% right now.

Transferring the fund to cash now will mean realising the losses it has already made. It may be better to wait until the fund has recovered before even considering moving it elsewhere. There's no question that had the CTF been held in cash, rather than being invested in the stock market, it would be worth more today.

 But that said, I still think shares provide better prospects for growth over the next 12 years. (Still, I could be wrong.)

What about tracker CTFs?

CTFs can also be invested in index-tracking funds. Here at The Fool we're big fans of trackers for older investors, but they could be a good bet for younger investors too.

So how do tracker CTFs work? In a nutshell, the fund will invest in all the shares quoted on a particular share index -- such as the FTSE 100 or FTSE All Share -- with the aim of matching, or tracking, its performance as closely as possible. Trackers are a good way for first-time investors to dip their toes in the stock market, and I think they could be an appropriate investment strategy for children with CTFs too.

Catch Question of the Week #5 next Friday!

Editor's Note: This article should not be seen as individual advice for Fool229479135. We don't know the full financial circumstances so we can't say for sure whether investing in a child trust fund which holds shares is appropriate for Fool229479135's grandson.

More: Find out more about saving for children at The Fool | Question Of The Week: Are Pensions For The Over Fifties Worth It?