Capital protected products have the advantage of allowing investors a preview of the level of risk and potential returns achieved by their chosen product, explains Jeremy Beckwith
The market for capital protected products has expanded significantly in recent times in response to investors becoming more risk averse during the bear market - the result of seeing significant losses to their equity investments during that time. This even resulted in some high profile pension funds making asset allocation moves to fixed income investments, and created demand for a new breed of product that could provide capital protection. Today, the most visible trend in the capital protected product market is their ready availability in the retail marketplace. High street banks and even the Post Office now routinely offer protected stockmarket products to retail investors, often accompanied by prominent advertising.
A welcome side effect of this has been to create a much higher degree of competition in the terms that are offered by different retail providers: the returns available (also known as participation rates, where investors 'participate' in the growth of the underlying) and level of capital protection often vary dramatically between different products and providers. Greater competition in turn drives product providers to develop a deeper understanding of the products they offer and to demand keener pricing from investment banks. This has created an element of fee compression as the market has become more sophisticated, and as individual investors - and providers - can more readily discern what is good and not so good value.
The composition of these products in the retail marketplace has not yet evolved much beyond offering protection and participation on the main equity indicies. However, within the private banking industry - which is often a harbinger of product developments in the retail market - there has been a noticeable widening of the range of asset classes that can be used within capital protected products. Funds of hedge funds, unit trust funds of funds and commodities are all areas that have seen product launches in the last year. In addition, there has been a noticeable pick-up in 'rainbow' structures that combine several different asset classes within a single product. These will typically benefit from diversification effects that effectively cheapen the options underlying the structure and can lead to higher participation levels for the product.
CDO popularity rises
Recent publicity has highlighted the size of the collateralised debt obligation (CDO) market, which has historically been an arena accessible primarily to the institutional and hedge fund industries, although this is beginning to change. CDO's repackage portfolios of corporate bonds into different risk buckets, each with a designated risk level. Typically insurance companies have taken the highest-rated pieces and hedge funds and proprietary trading desks the lower-rated tranches. The pieces in the middle (around AA or A rated) have some appeal to the private banking market as they give access to a much more diversified portfolio of corporate debt than private clients would normally be able to access. Although these are not guaranteed capital protected products, in practice a well diversified CDO would not be expected to produce significant losses.
In the UK market there has been a clear trend towards developing capital protected products within tax efficient structures, which further broadens their appeal to investors. For hedge funds, the use of Guernsey protected cell companies listed as closed-end funds on the London Stock Exchange has become common, many of which also offer capital protection.
Capital protection within UCITS III
The Ucits III legislation now permits a far wider range of investment strategies for approved funds in the UK (and technically for the rest of Europe too). It is now possible to put structured products into a Ucits III fund. This has two major advantages: firstly, it is tax efficient for onshore investors, and secondly - because a fund has dealing points and is open-ended - there is a major advantage when marketing it to a retail or private client base due to the additional liquidity that it provides.
Overall, capital protected products are becoming more well-known, more competitively priced and better understood. They have a place in many portfolios, since they offer the possibility of achieving tailored risk-return trade-offs, as well as providing an effective method of accessing asset classes that were previously unavailable to smaller investors.
The underlying methodology for generating capital protection is essentially the same for all products, although the precise method of implementation will vary.
The purchase of a zero-coupon bond with a maturity equivalent to that of the desired product is the means by which providers are able to assure investors that their capital is protected. Since the zero-coupon bond will, by definition, be trading at below 100 (by how much will depend on the appropriate interest rate for the currency, the maturity and the credit rating of the issuer) the balance of the investment is available to be used for the purchase of geared derivative instruments of the underlying asset or asset class.
These derivatives can be set at the outset and never changed, or they can be managed as a portfolio in order to try to achieve better returns.
CPPI - not a universal solution
This second method is the one used in Constant Proportion Portfolio Insurance (CPPI) structures where the manager will use leverage to adjust the amount of derivatives purchased. As the price of the underlying asset falls the manager will tend to reduce the exposure in the derivative portfolio, in order to reduce the risk in the portfolio, and as the asset price rises so the manager will tend to add to the risk in the portfolio. This structure tends to produce the best returns for those assets that have the least volatility, but performs less well with assets which have much greater volatility and move in a trading range. If the price of the asset falls near to its floor value, there will be little cash available for purchasing additional derivatives in order to manage the portfolio, and so there is a danger of being 'cashed-locked', where there is no cash available to take advantage of rising markets.
Buying as the price rises and selling as the price falls tends to go against the intuitive investor norm of seeking to buy low and sell high. In addition, the asset classes that benefit most from this structure are precisely those for which capital protection is least necessary since assets with low volatility are unlikely to see significant drops in value. CPPI structures are therefore most commonly found where it is difficult to write options on the underlying assets, for example, hedge funds or mutual funds, as the structures are particularly opaque and therefore leave lots of scope for hidden charges.
By keeping to the first method, where the derivatives used are established prior to the start of the trade, defined returns can be established from the outset, giving investors an advanced preview of the precise mix of risk and potential return that will be achieved by the product. This also means that differerent levels of protection can be offered, and it is also possible to create structures where returns can be locked in along the way.
Certain asset classes becoming more widespread, for example, funds of hedge funds.
Ucits III permits a far wider range of investment strategies.
CPPI structures tends to produce the best returns for those assets that have the least volatility.
SM&CR is the big one
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