By David Griffiths Dublin-based protected products have changed a great deal since their introduc...
By David Griffiths
Dublin-based protected products have changed a great deal since their introduction five years ago but this development has not entirely benefited investors.
During this period, the cost of derivatives backing such products has gone up, ensuring that more recent launches have not been able to offer investors the same bang for their buck.
Adam Fairhead, head of product development at JP Morgan Fleming, said the cost of the underlying investments in these type of structured products is dependent on interest rates and the expected volatility in the market.
According to Fairhead, the lower the interest rates the higher the cost of the bond, so less money can be spent on options.
In addition, if volatility is higher than expected, an option which is meant to counterbalance volatility costs more.
He said: "If you have high expected volatility and the actual level turns out to be less, which is often the case, then you are paying too much for your protection."
In June 1996, HSBC launched the first of its Dublin-based Pep Plus vehicles, maturing on 26 June this year.
Looking back, the terms of the capital protection product would be considered extremely generous by today's standards, giving returns based on growth of the FTSE 100 over the five year term, plus a further 33% of the growth as a bonus.
At the start of the product's life, the FTSE 100 was at 3,679, while at the close of business on 24 April 2001, the index was at 5,840.
If it were to mature today, returns from an initial investment in Pep Plus would have increased to just over 57%, or in cash terms (based on the investment of the full Pep allowance of £9,000) a return of just over £14,000. This return has taken into account the effects of two market downturns over the past five years.
By comparison, from April 1996 to the end of April 2001, the FTSE All-Share is up 49.85% while the UK All Companies sector average is up 62.53% over the same time period.
Many who invested in the original HSBC product may be looking to reinvest money in a similar vehicle. HSBC intends to launch a rollover vehicle aimed at existing investors in the Pep Plus product, which at its launch had raised some £67m. The new product is being created to resemble the original, as far as possible.
Alison Savage, HSBC's head of marketing and business development, said: "One of the strengths of Pep Plus was its simplicity. We will be offering a competitive product that will probably be broadly similar to the one we had five years ago."
However, she warned that providers were now unable to offer the same terms available five years ago due to the rising costs of the underlying derivative instruments.
Patrick Connolly, associate director with Chartwell Investment Management, urged caution when considering the merits of newer guaranteed bond schemes or Dublin-based products. He believes today's versions are unlikely to provide the impressive returns of earlier vehicles. The reason for this, he said, was that rising costs of the derivatives used to back high growth plans were squeezing the profit margins of providers.
The downward sloping yield curve means that one-year rates are higher than those for five years, therefore it might help to price a one-year or three-year bond rather than a five-year, he said.
Investors can look at HSBC's subsequent launches for an example of just how much the market has changed in a relatively short period. The group's second offering of Dublin Peps, Pep Plus II, featured the growth of the FTSE 100 plus an 18% bonus. Progressively, the bonus has shrunk in size until the sixth and final product of this kind, Pep Plus VI, which was launched in August 1997, promised investors returns of 20%, plus the growth of the FTSE 100 over 20%.
The high cost of derivatives has meant providers have by and large moved away from the full capital protected growth schemes that first characterised this market.
Increasingly, income based instruments have become the norm, with returns of 10%-12% gross designed to catch the eye along with some element of capital protection but not the 100% protection available in the original products.
"The terms available on these types of schemes just aren't as good as they used to be," Connolly said. "They are designed to offer a more stable rate of growth and have less emphasis on protection. Additionally, providers are now far more likely to offer maturities of three years or a year, rather than five years. The longer the maturity, the better the chance of investors seeing a good return on their money.
"Clearly, with a maturity of just one year, the capital risk to investors is bigger as there is less time available to recover from a downswing in the markets."
According to Connolly, more recent offerings by providers such as Scottish Widows and Eurolife show that not only are product providers offering products with a shorter duration but the instruments themselves are becoming ever more complex.
In February and March 1999, the popularity of such vehicles was high with a number of groups offering products, including Eurolife, GE Financial Management, HSBC, Legal & General and Scottish Widows. However, the majority of these were three-year vehicles as opposed to five and they featured higher income options rather than 100% capital protection and growth.
Scottish Widows launched a capital protected Dublin Pep at the end of the 1999 Pep season and the popularity was such that it met its subscription limit within nine days. In December 2000, the group launched a second version of the product, the Scottish Widows Stockmarket Growth Two. The Dublin-listed company invests in a basket of 30 FTSE 100 equities, which are equally weighted. Its aim is to provide a 10.25% annual income for three years or 33% after three years and two months.
Within the basket will be companies such as Abbey National, Vodafone, Barclays, BP Amoco, British Telecom, CMG, HSBC, Marconi, Misys, Reuters and BSkyB.
Linking products to the performance of a volatile index or a basket of shares is now common in order to provide attractive returns. Almost inevitably, this means that these products will carry a greater risk to returns, and in non-capital protected plans, to the original investment itself.
John Churm, a financial adviser with Torquil Clark, shares Connolly's concerns about the type of capital protection plans currently on offer. He is worried that impressive headline rates could be leading investors into high risk plans without paying enough attention to the detail of how the returns are to be achieved.
There is a danger, Churm said, that investors may buy into the marketing spiel of these products without understanding the underlying product.
Churm cites the example of Credit Suisse First Boston's new Tessa Triple Plus, a derivative-based product that boasts capital protection and potential growth of 100% over five years. Unlike many other derivative-based products there is no lock-in protecting early gains from later falls in the market, and, as there aren't any shares, there is no possibility of any dividends.
Churm said that with this product, in order to achieve 100% growth, investors need the stock market to grow by 10% every six months. He believes that a more realistic assessment of returns on this product would be something in the region of 16%-19% over five years.
Torquil Clark does not actively market guaranteed bonds, preferring to guide clients towards index trackers or actively managed unit trusts instead. Churm said his company preferred simpler investment instruments with more transparent returns.
One of the strengths of HSBC's Pep Plus, Churm said, was its straightforwardness, compared to newer schemes which rely on more complex structures.
He said: "In order to get the attractive headline rates that bring in investors, product innovators such as NDF and Eurolife have linked products to indices like Nasdaq and Eurostoxx, which are prone to more violent fluctuations.
"They are also providing capital protection but this comes at a cost. Not only will you be charged for the protection but potential returns are also capped. An investor looking for big yields is going to be prepared to take bigger risks than most investors.
"Why pay for protection and limit your returns when you could be better off investing your money elsewhere?"
Churm said value does exist in the guaranteed bonds market, particularly in the Tessa rollover market.
Torquil Clark suggests, for example, that those clients who may have had their interest raised by CSFB's Triple Plus product should perhaps look at HSBC's Performance Plus Tessa, which it believes is a much clearer product which still offers capital security.
Future Value Consultants, risk management and derivative specialists, runs a service through its website that IFAs may find useful when advising clients on the merits of guaranteed bond vehicles.
The website, www.futurevc.co.uk, assesses the merits of each new product, highlighting the strengths and weaknesses of each, as well as giving them an overall score.
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