The global financial crisis has seen a flight towards capital protected products.
Investors who have seen the value of their portfolios fall over 50% in some cases have pulled their money out of the market and invested it in the “safe haven” of capital guaranteed products to prevent further losses.
But those same investors could be setting themselves up for guaranteed disappointment as these products are often not what they appear to be and more importantly are not suitable for many investors.
The idea of ‘capital protection’ is that investors would normally receive a minimum of 100% of their initial investment, provided they hold it to maturity (which is normally a term of at least 5 years).
Let’s firstly consider the techniques used to be able to provide the guarantee of capital protection (if you have limited investment experience you may wish to skip over these three points as they are quite technical):
Zero-coupon plus call. The investor effectively purchases a zero-coupon bond that protects the principal with approximately 80% of their investment. At maturity, this is expected to be valued at the purchase price of the investment. The other 20% is used to buy a call option on an asset (eg ASX200), providing possible upside through exposure to the underlying asset.
The downside is that the volatility of the underlying assets determines the call price of the option. Therefore, if the underlying asset is very volatile, the call option is expensive and less can be bought from the money invested. This can significantly reduce any growth on the investment.
Put options. This option gives the holder the right to sell an asset at a pre-determined price. A structured product can purchase appropriate put options over the basket of underlying securities. If the basket of securities declines in value, the put option will be exercised, thus allowing the issuer to realise the initial value of the investment.
With this option, the investor is fully exposed to the asset and will benefit if the asset performs well, although there is a cost associated with put options, which can have a negative drag on returns.
Constant proportion portfolio insurance (CPPI). At the outset, a ‘bond floor’ is calculated, which represents the present value of the product at maturity. The gap between the bond floor and the investment is known as the bond fall. A calculation is performed to determine how much needs to be invested in lower risk investments in order to achieve the bond floor. The underlying assets are then invested and depending on their performance, the exposure shifts between higher risk / lower risk investments. For example, if the portfolio performs well one month, exposure to higher risk assets will increase, if the portfolio performs poorly the next month, part of the portfolio will be replaced with a safer investment.
Whilst the above methods have been able to deliver a capital guarantee to investors in the past in most situations, the main issue is timing the market. Sure, if an investor went into a five year product in November 2007, they would certainly be better off now than an investor who invested in the more traditional markets at that time. However, with strong growth up to November 2007 (particularly in the Australian market), the idea of investing in a capital guaranteed product would have been unthinkable to most investors who were hungry to capture some of the growth in the marketplace.
It is only now, that investors have been faced with heavy losses that the thought of a capital guarantee is attractive.
However, this is the worst possible time to invest in a capital guaranteed product.
One of the fundamental rules of investing is not to panic when equity markets struggle, stay invested and markets will recover. They always have and always will…it’s just a matter of when. Pulling out of equity markets at this stage will only compound the losses and move you to a product that generates lower returns, making it more difficult to recoup the losses.
Also, there are other important factors when considering capital guaranteed products.
The impact of inflation. Even if an investor receives their initial investment back at the end of 5 years, inflation (or the increased cost of living) has actually eroded the real value of their money, effectively generating a capital loss for the investor.
Long term investing. Over a term of at least 5 years, you would expect most investment markets to generate a positive return. Short term volatility is ‘ironed out’ when an investment is held for a long term.
In fact, the All Ordinaries Accumulation index over five rolling year periods, moving forward one month at a time (starting in 1980) has been zero or negative for less than one percent of the time over the past 28 years. This means that since the 1980s the Australian Equity market has virtually capital protected itself.
A tried and tested method of risk reduction is diversification. This involves spreading your money across a range of different asset classes such as cash, fixed interest, property and Australian and international equities. Each of these markets moves in cycles and when one is normally performing poorly, another asset is normally generating strong returns. The result is more consistent returns.
Those who have an aversion to risk can have a higher proportion of more conservative assets such as cash and fixed interest whilst those with a higher tolerance for risk can invest in a greater proportion of growth assets. The probability of negative returns for a ‘conservative’ portfolio (which has an allocation of 70% in conservative assets) is only 4.9% whilst a ‘high growth’ fund (with 94% invested in growth assets) is 20.2%. Of course, the portfolio with a greater allocation to growth assets will deliver a greater long term return. The issue is ensuring your portfolio is suited to your risk tolerance to ensure that returns are within your expectations.
Whilst traditional investments cannot provide a guarantee of capital protection, by using diversification and investing for the long term, a return of your capital, along with portfolio growth is almost a certainty, without expensive fees and complex structures wiping off the bottom line.
Guarantee your investment performance by getting back to basics, removing emotion from the investment process and avoiding capital guaranteed products – particularly at this point in the economic cycle. Don’t be fooled by capital guarantees that are guaranteed to disappoint.
