Capital protected investments can be a useful tool for the cautious investor while still providing genuine value. Bill Blevins points out, however, it is important to make sure the product meets your overall investment objectives
With low interest rates and volatile markets, it is no surprise that products specifically structured to provide a middle ground between direct investment in equities and bank and building society accounts have sprung up and become more widespread. Capital guaranteed products can be a genuine and welcome alternative, especially if they offer a 100% or more as a guaranteed minimum return.
Capital protected investments can - and many do - provide genuine value, but this does depend on whether the returns on offer are of value and not compromised by the levels of capital protection. Also, while the accompanying literature can present them as simple and safe products, they are usually based on complicated structures which the investor may not be aware of, with the result that they may not fully understand the risks and could be disappointed when the investment matures.
It has to be remembered that what we are discussing here is an interest rate swap. The investor is exchanging the rate of interest to be earned over the period of investment for the potential of a higher return by linking profits to improvement (normally) in a stockmarket index over the period.
There are a myriad number of options available to the provider of such investments on exactly how the return is to be calculated. But, in essence, the product providers are all working with the same interest rate swapped, it is then really just a case of how they put the product together and market it. The key difference to potential returns between most products is the rate of commission paid by the product provider.
There are various types of capital guaranteed products, offering a variety of returns and risk profiles. Most of them provide a return linked to the performance of one or more stockmarket indices. Many have a pre-determined maximum payout subject to index performance. Almost all have protection built into them to make sure that the invested capital is not exposed to stockmarket declines, although some do carry the potential for losses in certain circumstances.
The return from some of these funds is measured against the average performance of a basket of equities, but other funds track a single stockmarket index, often the FTSE 100. The index or indices chosen will affect risk and return levels. Where the return is measured by the performance of a number of indices, it is important to ensure that each index is 'ring-fenced' to prevent good performance from one or more index from being reduced by losses experienced in another.
Many products limit the growth potential by either applying a cap (for example, 75% growth over five years) or via a level of participation (for example, 75% of the average growth of the FTSE 100). Some combine both methods. On the other hand others offer 100% participation or even more than this (for example, 120% participation or a bonus if the underlying indices on the final date are equal to or above initial index levels).
The main criticism of these products is that the risks involved are not self-explanatory, and that brochures (and sometimes advisers) do not explain them fully to the client. Usually the products offering the most exceptional returns will carry additional risk and your clients should understand this risk/reward relationship before signing on the dotted line.
The capital guarantee is probably the biggest selling point of these products. However, this capital protection necessarily comes at a cost. First of all, the 'capping' element would mean that the investor loses out on some of the possible rises in the equity market. If the investor had chosen to invest directly in equities instead they would benefit from 100% of the rise (but with the accompanying risk of capital loss.)
Secondly, increasing level of an index on which performance is measured is based on capital values. Therefore investors in such products will not benefit from dividend payouts, which would provide increased overall performance from a direct investment.
Buying equities in the chosen index instead of a guaranteed product linked to the same index means that the invested capital is unprotected and some of it could be lost. Paying the price of a capital guarantee may therefore be a wise decision, but only once all the facts have been weighed up.
The product provider of the guaranteed product does not take the investment risk on themselves. They normally use third parties, usually highly rated banks, to provide the tools necessary to create returns for their clients. If these counterparties default, the loss is borne by the client. This risk is actually very low, as highly rated companies are used, but the client is not always aware of this aspect of the risk.
100% guaranteed investments may appear simple, but they are rarely so in practice. Structured products are becoming increasingly difficult to build due to changes in the markets and interest rates and the rise in costs of the investment instruments that are used to generate the returns. In order for product providers to still be able to offer attractive products, they have to turn to more and more complicated structures. This complexity may not be ideal for the low risk investor for whom such products were originally intended.
If, however, the product offers an absolute guarantee of a minimum return of 100%, then the risk is limited. Indeed, it may only be the loss of interest that would have been earned had the money remained on deposit.
Although on the surface these products look the same, they are in fact built round different concepts, structures, underlying headline rates, methods of calculating gains etc. One needs to analyse each product's literature separately.
This complexity has a few implications.
Calculation of returns
Often the levels of complication built into a product and the accompanying literature make the returns look far better than they are. For example, they may boast about excellent returns when the chances of receiving them are virtually nil. What happens is either that the market conditions that are needed to produce these returns are highly unlikely to happen, or the method of calculating the return will probably work against the investor - or both.
There are various methods of calculating what the returns will be based on:
• Look back: This method looks back over the final four or six weeks of the product and establishes what the lowest level was at any point of any day over that period. If the fund matures during an uncertain time in the markets the risk can be substantial.
• Cliquet structures: This divides the investment period into sections of a set number of months, and then gives the investor a sum of the gains and losses. However, although gains are usually capped, losses are not, and it is the investor who suffers.
• Averaging: In this case, the return is calculated by looking at,for example, three-month periods over the term. This can provide protection in the event that the index to which the investment is related falls significantly towards the end of the investment period.
Who are these products suitable for?
If your client would prefer to benefit from the full growth equities can provide, then opting for a 'safer' guaranteed product is probably not the right investment choice. If, however, they are wary of equities, do not want to risk any capital losses and are frustrated with low interest rates, these products may be the answer.
Besides this they can be a good stepping-stone to equities and provide first time investors with an introduction to the stockmarket world without the risk.
They are useful to help diversify an investment portfolio or act as a stable 'core' to a more diversified portfolio. If your client already has equities and bonds they may be interested in investing some funds into a capital guaranteed product to help balance volatility risk. In fact, intermediaries would not often recommend choosing guaranteed products over equities or the other way round, but rather hold both in a portfolio. This diversification would allow for gains if the markets rise over the investment term, at the same time as having some capital protected during downturns.
It is also an idea to use these products to protect a client's profits. Once a year, your client could take the profits they have made on their equity and bond portfolio and, instead of reinvesting them back into assets which could depreciate in value, place them within the relative safety of a capital guaranteed product. A great deal depends on the client's timeframe and whether they can afford to tie up capital for the length of the fund (usually five years). Investors may be penalised for early encashment and/or lose the capital protection.
A guaranteed product could very likely be a suitable investment for a number of investors. It is important, though, to not judge a book by its cover and make sure the product chosen is transparent in its objectives and construction, and that it meets the client's overall investment objectives.
Many products limit the growth potential by either applying a cap or via a level of participation.
Capital protection usually comes with a cost, capping element means that the investor loses out on some of the possible rises in the equity.
However, buying equities in the chosen index instead of a guaranteed product linked to the same index means that the invested capital is unprotected and some of it could be lost.
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