Capital protected products are under the microscope
21 November 2008Like all investment classes, capital protected products are under the microscope. But for canny investors looking to the long-term they still offer value.
No different to any other investment vehicle in the current climate, capital protected products are under scrutiny. But as with Mark Twain, reports of their death are being greatly exaggerated, and for astute investors they can play a critical role in helping meet their investment goals.
Capital protected products have emerged over the years, in Australia and overseas (including Developing Countries), as investors look for an investment that still offers capital gain but promises to “protect their capital”. Their sales have typically been through financial planners or the banks’ wealth management divisions.
In particular, many people use these products in their portfolio construction, encouraged by the fact they provide capital protection, which limits the loss in falling markets, and offer access to markets and investment themes that typically cannot be accessed through the stock market.
Capital protected products have been associated with the structured collateralized debt obligations products that attracted local government, hospitals, universities and other public institutions; in New South Wales alone, a report has found councils have a combined exposure to collateralize debt obligations of $1 billion of which some were with the collapsed investment bank Lehman Brothers.
As a consequence these products have been labeled “intricate” and “risky” because of their use of asset classes outside the traditional bonds, property, and equities. It’s an unfair description.
Rather they should be viewed as a package that combines many parts that an investor should look at – tactical asset allocation, sensible leverage and tax efficiency – into one package, a capital protected product, and now are performing in line with expectations in the current volatile market conditions.
So how are these products protected? There are several methods, and all come at some cost.
- A simple capital guarantee where the issuing institution uses a hedging strategy on their balance to offset risk.
- An options strategy that allows the gains in the good years but protects on the downside in the bad years.
- Using a zero coupon bond, issued by a bank, that returns an investor’s original capital at maturity
- Continuous portfolio protection insurance; involves switching the capital out of the underlying investment into cash if it’s falling in value and sets off a trigger point.
In today’s far more sober investment environment, where commonsense suggests capital protected products should be thriving, there are some question marks.
Principally, there are two issues putting these products under a cloud. Firstly is the fact investors are even wary of the institutions (typically banks) that stand behind the fund manager offering the capital protected product. Counter-party credit risk cannot be discounted.
There can be no doubt that the collapse of investment banks such as Lehman Brothers has severely dented investor confidence. In the past a Macquarie Bank, ANZ or CBA gave investors the sense these products were bullet-proof. Today, in large part because of what has unfolded overseas, we are not so sure – witness the need for the Federal Government to intervene to guarantee bank deposits.
Secondly the current large and unpredictable volatile moves down, combined with sharp movements in interest rates, have affected the participations rate in the existing capital protected products. That said these products are still achieving their key goal – protecting your capital - but the cost is a low participation rate to the underlying market. However, many are currently outperforming their underlying markets.
Capital protected products can be described as having varying degrees of risk, just like any investment. The common thread is the protection of capital. For the cautious investor, low-risk capital protected products are almost akin to a fixed deposit. But as the risk curve grows so does the opportunity for the investor to earn a higher return, while always knowing their capital is protected.
But before investors throw the baby out with the bath water, it’s time to take a deep breath and consider what capital protected products still offer, especially for portfolio construction.
They still give investors the opportunity to gain exposure to investment themes with reduced downside volatility and can also add leverage to a portfolio without having to face margin calls. This allows an investor to gain the necessary exposure to markets, to achieve their goals, without having to significantly rebalance their portfolios.
Margin lending as a wealth accumulation tool will be re-thought, and its replacement may be capital protected lending strategies. Protected lending can be expensive compared with margin lending, but the piece of mind that it provides will be a big component of delivering investment strategies to clients going forward.
Choosing the right investment theme while having capital protection is an attractive option for investors. They might believe that certain commodities, such as iron ore and coal in the wake of the industrial revolutions occurring in China and India, offer long-term value, but are wary of the downside risk of investing in stocks that are exposed to these markets because of the multiplicity of factors, such as currency movements, that can have an adverse impact on their share prices A capital protected product can offer them the security of locking in their capital while giving them exposure to an asset class they believe has upside.
These products can also offer the potential for distributions, profit lock-ins and capital growth, while, at the same time, offering capital protection. The industry is actively listening to the financial adviser and investor and improving on their offerings, increasing transparency and liquidity. Products can also minimize any foreign exchange risk via daily hedging mechanisms.
Well designed capital protected products have outperformed their underlying share markets over the past 12 months. Investors do value capital protection and as long as the protection is robust, these products will continue to be enjoyed for the wealth creation and control they deliver.
What individuals have to do with these products is no different to any other investment class. They have to choose the product that blends their individual needs and goals with their investment philosophy and, for individuals either nearing or in retirement, in particular, this could still prove to be a capital protected product.
