Although the structure of derivative-linked products has become increasingly varied over the last two...
There are two main types of derivative- linked fund presented as 'capital-protected' or 'capital-secure' - these are safety-first funds and rolling (usually quarterly) funds.
Safety-first (or ratchet) funds work on the principle that the attractiveness of a traditional equity fund can be enhanced by providing a protected level below which the unit price cannot fall over a certain period. The protected price is established on each fund anniversary and is normally set at about 90% of the unit price at that time. This price may be 'ratcheted' up during the year if the unit price has risen by more than 10% since the start of the year. Although during each year the protected price can only be increased, it may be reduced on the next anniversary if the unit price has fallen.
The protection is provided by the fund buying put options on the underlying assets that will pay out if the unit price fails during the period. If the protected price is to be ratcheted up the option position will be closed out and a new contract will be established with a higher strike price.
Due to the availability of options, the underlying fund will broadly follow the performance of an established stock market index, although the fund will underperform due to the cost of the options and the fund management charge. This has been particularly true recently as market volatility has been at or near historically high levels over the last year or so.
Although the protection provides a valuable safety net against sharp falls in the unit price, it does not always offer investors a precise level of protection. For example, if an investor buys units at a time when the unit price has risen 7.5% since the protected price was last set, the unit price could fall by more than 16% before the protection would take effect. Of course, an investor could benefit from a better level of protection than 10% if the unit price at the time of investment is lower than it was when the protected price was set. The positive side of this argument is that investors can enter and leave the fund whenever they wish. The most high profile funds have been offered by Scottish Widows, Edinburgh Fund Managers and Gartmore.
Safety-first funds can be attractive to investors that want to have significant equity exposure but are willing to sacrifice some of the potential upside to protect a significant part of their capital. Investors generally accept that returns will fall somewhere between equity and deposits.
These operate in short periods over which the protection is provided and any growth is generated and then locked in. These periods may be as short as a quarter or as long as a year. Most successful products have been quarterly rolling funds as this is short enough to provide liquidity and long enough to provide sufficient growth. Protected levels for quarterly funds usually range from 95%-100% while annual rolling funds will offer levels between 90% and 100%.
Investors should be aware that where a level other than 100% is chosen, there may be a compounding effect if no growth is generated over successive quarters. For example, investors in a 97% protected fund that generates no growth for two quarters will lose nearly 6% of their capital over that period. Provided this important point is understood, the major attraction of rolling funds is that, because protection is provided at the investor level, the risk to capital can be easily calculated.
The underlying mechanism and assets of rolling funds differ greatly from the safety-first funds described above. While safety-first funds operate on a 'stock and put' basis, rolling funds operate on 'cash and call'. This means the cash provides the protection while the balance is invested to create the growth.
This growth may be generated by investing in single index call options, a call option on a basket of indices, a digital option or a managed fund of options. The most popular single index products have been provided by companies such as Scottish Life International (SLI), Scottish Mutual International (SMI), Close Brothers, Manor Park and Scottish Equitable International (SEI).
SEI and SLI both have global variations and SLI uses an innovative computer model to determine asset allocation between the world's four major markets. Digital options that pay out a fixed amount if an event occurs have been exclusively issued as part of SLI's Protected Deposit Bonus funds, which pay a bonus if neither the FTSE 100 and S&P 500 falls over a quarter.
SMI's managed variant initially promised much, but the performance has been poor over the last year or so. The most recent innovation has been provided by Edinburgh Fund Managers, which launched a six-monthly rolling fund earlier this month that provides upside-linked a number of indices but which also allows investors to enter and leave the fund on a monthly basis without penalty. Furthermore, the protected price may be increased each month if there has been sufficient growth in the value of the underlying assets.
It is important to appreciate that the type of asset used to generate a bonus for each type of fund will produce different returns in different circumstances. Also, the structure of many rolling funds gives investors the opportunity to outperform equity markets by risking a higher level of capital over the period, refuting the often-held belief that al
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