Capital protected products have become popular following the 2000-03 bear market. They have also attracted criticism for being opaque and difficult to understand but these criticisms are not necessarily fair, says Richard Jamieson
Protected or structured funds have come into their own over the past five years. The bear market from 2000 to 2003 has obviously played a major part in creating a demand for this type of product, but it is also been interesting to note that the supply of these products has come, not from the fund management industry, but from the life assurance companies and banks.
To some extent the fund groups have had their hands tied by the product regulations they have had to contend with, so it is only recently that they have had the scope through Ucits III and the new COLL regulations to attack this market. As a result, some unfamiliar noises are starting to be heard from that camp such as the sudden heightened emphasis on absolute returns, target returns or cash-plus returns and bold statements such as 'downside protection is key', 'total return is more important than absolute return' and 'we need to recognise that investors have an asymmetrical attitude to risk and return' (quoted from some well-established names and all witnessed recently first-hand by the author).
Meanwhile, the structured market continues to flourish, although the pace of expansion has inevitably slowed. Clearly there are a lot of investors and advisers who have been switched on to structured products, but for those who still harbour suspicions, what are the most common objections and are they justified?
Objection: Protected funds are just too complicated
This is an understandable objection borne out of unfamiliarity with the product type when an investor or adviser is taken out of their comfort zone. Having analysed and accepted traditional actively managed investment funds for what they are and having become comfortable with the concept, it can be difficult to see how protected funds work, especially if complex option combinations are utilised. However, the emergence of the structured product over the last five years has tempered this objection as increasing numbers of investors and advisers make use of them and, hopefully, make money out of them.
At the basic level, these products are extremely simple to understand as many consist of only two elements - cash for protection and options for growth. It is then just a case of understanding the payoff mechanics of the option. Granted, this could have a degree of complexity, depending on the option, but here is the beauty: once you do understand this, then based on a future level of an index, stock or fund (depending on the option) you will know the exact performance of the product.
Contrast this to an actively managed fund. Not only will you have no idea of any future performance level - even given a set benchmark performance - but the way in which the performance is derived - the investment process - is just as, if not much more, complicated than an exotic option payoff. How much effort is involved in penetrating and understanding the investment process of each fund house and the investment style of each fund manager?
A great deal of this is therefore taken on trust - trust that the process will deliver what the fund house says it will; trust that the fund manager delivers the goods. If it does, then all well and good; but if it does not, you could end up looking like a right chump. This is increasingly becoming a much too onerous area for intermediaries to devote their precious time and many are taking the view that it is worth employing external experts - hence the rapid rise of the fund of funds sector, where fund analysts can devote their energies and flex their muscles.
Objection: The cost of protection means that you lose out on the performance upside
This is by far the most popular objection to protected funds, but which needs to be treated with caution. In all walks of life you do not get anything for nothing. Protection costs money - it is a fact. What is more, the greater the level of protection you choose to build in, the more expensive it will be.
However, this does not mean to say that you cannot get access to levels of high performance. What is does mean is that once you have defined and booked the level of protection you are comfortable with, you can then decide what to do with the rest of your investment return. Instead of just buying a bog-standard asset, you can take some risk with this part of your investment and get something really racy - after all, you have already bought your protection. As long as you are not going to kill the golden goose by going short then the potential returns could be surprising. For instance, buying a protection level of 97% over a three-month period could give you 200% participation in the FTSE 100 index. If the index falls or only rises by 1.5%, then the option would not restore your original investment.
However, if you had taken this strategy then you would have already specified that you were comfortable with protecting only 97% of your investment. If, on the other hand, the market had grown by 5%, then the option would add 10% to your protected level and give you a return of 6.7%. Similarly, the latest longer-term products are also offering potentially index-beating returns, such as a six-year product with 100% capital protection and 130% of the growth in the FTSE 100 index. Performance with protection: crazy.
It is also worth pausing a moment to look at the actual value of the protection involved, as this is often not fully appreciated, especially when it is masked by extended periods of bull markets. A protection level provides hard capital protection at a defined level which prevents the fund value falling sharply during a bear market. This is the most obvious way in which protection can benefit investors. Arguably the greatest benefit is a little less appreciated.
This is how it works: if your investment has fallen by 20%, it will need to grow by 25% to get back to its original value; if it falls by 50%, it will need to grow by 100% to recover the lost ground; if it falls by 75%, it will need to grow by 400%. The elastic just keeps on stretching. By defining a level of hard protection, protected funds reduce the extent of the fall and can therefore rely on smaller future growth levels to get back to where they started. What value would investors in technology funds have placed in such protection over the last five years? The average technology fund still needs to grow by 322% to get back to its starting point five years ago. Hopefully, most people will now understand that such adverse periods in investment markets are not necessarily that rare an occurrence.
There is no magic formula for making money; you cannot have your cake and eat it. However you choose to describe it, there is a simple pay-off formula between risk and reward which cannot be broken. The question is: which is most important to you? If, as is arguably the case with the majority of investors, the starting point is 'do not lose my capital', then structured products can play a key role in matching the defined capital requirements of the investor and then tailoring a reward profile around those capital protection considerations. Alternatively, if the emphasis is on reward, then there is no reason why the structured route should not also be appropriate. It merely lowers the prominence given to protection, so that the reward level can be defined first of all, with the protection level defined as a consequence. None of this changes the nature of the risk and reward profile in any way, though. It simply repackages it into a format which is more easily digested by the investor.
Protected products can be complex, but they are no more difficult to understand than the investment processes of active fund managers.
For more protected products, you can lose upside potential (but not always) and you are locked in but these are factors that can be identified and incorporated into an overall portfolio.
Bear market from 2000 to 2003 played a major part in creating demand for this type of product.
Putting the tech into protection
Square Mile’s series of informal interviews
Fallout from Haywood suspension
Launching later in 2019
£80bn funds under calculation