With the FTSE 100 exhibiting bearish behaviour, the smart investor backs guaranteed funds, writes AIG Life's Nigel Hewett
The FTSE 100 has lost more than 14% of its value over the last year and many investors have suffered similar losses ' the market becomes more bearish by the day. Investors with guaranteed products have suffered much less and will rebound from a position of advantage when the upturn comes.
Investors are suffering a rocky ride at present and many are asking their advisers what they should do. Any response should include a full appreciation of the role of guaranteed products in a diversified portfolio. Whether to buy or sell will depend on the individual's circumstances, but it must be best advice to increase the defensive element of portfolio when faced with the poor showing of all stock markets in the recent past and today's gloomy view of many commentators.
Guaranteed investments are perfect products for investors who wish to build up such a defence. It is at times like now, after the index has been resolutely adrift for so long, that the worth of guarantee shows.
Look at the FTSE 100. Here the market has been heading downwards or sideways for over three years ' into a well developed bear market. Investors who were in guaranteed products when the slide began are well ahead of their directly invested competitors who have lost up to 8% of their capital.
A wise investor in a guaranteed fund would, I believe, be one of very few to have made a profit in the same period. Investors exposed to the UK stock market are now feeling the pain of sliding numbers.
Putting the brake on a slide is quite a clever trick, but the financial services industry has had many years to perfect the techniques of protecting assets.
Hedging bets is an ancient discipline, but today, the secret of success is to have just as much of a guarantee that you want ' neither too much nor too little.
Some forms of hedging can be too expensive for their purpose and neutralise the whole investment. For example, a simple deposit-based savings account in a building society is perfectly safe, but over a period of time it is unlikely to beat the market or even inflation, so there is a cost here too.
Carefully tuned guarantee levels can give the investor exactly what they want. A really cautious approach would be the 100% guarantee, a total stop.
More flexible are the slightly lower levels: 99%, 98% and 95%. In each case, the stop-loss cuts in at 1%, 2% or 5% respectively. The investor's capital is as secure as they wish it to be but they retain exposure to the upside potential of the markets.
Management of risk
Market exposure is achieved through the elegance of a guaranteed stock market bond, which is a simple combination of cash deposit and call option investments.
In simple terms, at the beginning of each regular investment period, a large part of the investment is placed on deposit and the rest is invested in call options on the selected stock market. At the end of the period (typically three months), the deposit has grown to secure the full guaranteed value. The calls will have increased along with stock market growth to give the market growth element of the investment.
Clearly, if the market has fallen, the cash deposit provides the guaranteed sum: the option will be of zero value and is not exercised.
The proportion of the investment that is invested in calls depends on the level of guarantee required.
Broadly, guarantee levels available are 100%, 99%, 98%, and 95%, over successive three-month investment periods. The higher the level of guarantee, the less investment is left over to purchase market upside. This is expressed as a participation level, being a percentage of the growth of the chosen stock market index in the quarter from which the investor benefits. For guarantee levels of 99% or more, participation rates are generally less than 100%.
However, at the 98% and 95% levels, the participation rates may well be above 100%, reflecting the fact that the investor will be getting more than full exposure to the rise in the index.
The imaginative combination of derivative instruments can be used to provide risk free, or reduced risk, access to the world's stock markets.
For example, if an investor can accept exposure to a 5% downside risk every quarter, they can enjoy more than 100% of the growth of the chosen index on the guaranteed amount, a perfect example of the risk versus reward trade-off.
Packaging this mechanism in a retail product gives investors complete cost-free flexibility, allowing them to switch quickly and efficiently between levels of guarantee and stock markets.
But risk is more than just downside exposure. While absolute losses are the most extreme form of risk exposure, there is another type that is almost as difficult to handle, particularly for big investors and institutions ' volatility.
Investors seek to avoid price/performance volatility because it makes it very difficult to plan. Funding and investment strategies are often based on tight price/timings, and if valuations vary widely, such calculations are made much more difficult. However, volatility is an inherent feature of stock markets.
Rolling fund guaranteed equity bonds considerably reduce the risks of volatility, damping down price swings of the market by eliminating the downside. In this way, these bonds provide the required exposure to the stock market but without the volatility of direct investment.
A further technique for smoothing market swings that can be applied to these bonds is known as averaging. With each of the guarantee levels, except the 95%, the index is averaged over the quarter to calculate the gain.
This has a further smoothing effect, as the price at the end of every day over the three-month period is reflected in the average price rather than the one price on the end point day of the quarter, the 'spot' price.
While the total growth over a quarter may be constrained by averaging, this will be compensated for by a higher participation in the average growth.
Taken over a long enough period, market performance valued as a quarterly average when compared with a quarterly 'spot' work out to be the same, which is intuitive if there is no bias in the pricing of the different types of call options used.
A final point is the value of ratcheting. An investor with a 98% guarantee will only loose 2% in a larger market correction or crash. The market will resume with most investors at the lowest valuations, maybe as much as 28% off as in 1987.
The guaranteed investor, however, will have halted their losses at 2%, an effective stop-loss technique, enabling them to re-enter the market at a much higher value than the other investors.
This procedure would continue over a series of lesser gains/losses, locking in the gains ' the ratchet effect ' and minimising the losses.
There is no such thing as a low-risk, high-reward investment. Things that look too good to be true usually are. But derivatives, in the hands of experienced practitioners, offer a tailored balance of security and growth for most investors, providing a stop-loss mechanism to give the investor peace of mind and regulated exposure to the markets.
l Derivatives can offer a tailored balance of security and growth for investors.
l Guaranteed products are ideal for investors looking for defence against volatility.
l There is no such thing as a low-risk, high-reward investment.
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