Safety first: peace of mind comes at a cost – Smart Investor

Smart Investor, July 2009

Stephen O’Connell, like most of us, lost a lot in the last year and a half both through his stocks and his funds. “If I was looking at retirement today I’d be ready to slit my wrists after what I’ve lost,” he says. At age 50, the textile manufacturing managing director didn’t want to be in that position of uncertainty again – so he went for a capital protected product.

He opted for two Axa products, one a capital guaranteed super fund and one in equities, and was happy to take the seven year lock-in that comes with these products. “I can now say I know my worst case scenario in seven years,” he says. “The ease of mind is magnificent.” Would he buy more capital protected products? “120% certain, my friend. I’m working on it now.”

[See a PDF of this published article here: Capital indd]

He’s not alone. Benjamin Kohn is a regular user of capital protected investments. Three times now he’s bought in to Macquarie’s Fusion range, a product that exposes investors to a host of managed funds; he’s also used Macquarie Geared Equities Investment and taken out a margin loan to make capital protected investments. All told, they account for about 20% of his portfolio.

Products like these involve borrowing money for your investment, with a guarantee that you won’t be on the hook for that loan if the markets turn against you. “I prefer to be able to preserve my cash to buy property, invest in my business or put it into super,” explains Kohn, who runs a boutique financial advisory group called Link Financial Services in Caulfield, Victoria (he puts many clients into these products too). “And with respect to the shares, it gives me a higher exposure to the market with capital protection in place. I know I won’t have any margin calls, and the collateral is 100% protected.” He also knows that the interest he pays on the products is generally covered under ATO rulings and is therefore tax deductible.

So, how’s he done? He made a lot of money out of the geared equities product, and made money on one of the three Fusion investments. Two others didn’t work out – but at least it won’t cost him money. “The others have been affected by the economy not performing well, but it’s suited its course,” Kohn says. “If I had invested cash, or used margin loans, my capital would have been significantly reduced and I would have faced many margin calls. They’ve done what they’re meant to do, in good and bad times.”

This is the theory of capital protection: a safety net if your investment turns sour.

If you want to invest in Australian shares, for example, but are worried that the recent bounce in markets could be a false dawn and that there may be worse to come, you could buy a capital protected product that gives you exposure to gains in the stock market, but ensures you can never lose what you originally put in if the markets crash. Nothing is for free, of course, and the trade-off is usually either a bigger fee, a lock-in period that requires you to keep your money invested for several years, a cap on your gains, or (if the product involves a loan) a steep interest rate. But for some, that’s a worthwhile tradeoff.

 It’s not all about tax

In recent years, capital protected products have been driven not by conservatism but tax. You can get a tax exemption when you borrow to invest (although the terms of that exemption may be about to change – see below), and consequently many products have been developed in which typically you borrow the whole investment cost up front, with a guarantee that if the investment goes wrong you will at least be covered for the value of that loan. As much as these products are about protection, they are also a method of gearing in to the market – a big exposure to an investment without a correspondingly big (or sometimes any) cash commitment up front.

The wilder events of the last 18 months have brought about a change, though: many in the market report that investors are returning to the basics, looking for security rather than gearing. At JP Morgan, a long-standing provider of structured products with capital protection, David Jones-Prichard notes “a slight shift in the type of investors who are looking for capital protected products.”

“In the bull market years, 2004 to 2007, it was investors looking to enhance returns based on the gearing they could get,” he says. “Now it’s more real investors with cash to invest who want to dip their toes back in to the water. They like the value of equities, but are using that cash to invest through a capital protected product because they’ve either been burnt already or seen other people get burnt in the last 18 months and are more conservative. They want to sleep at night.”

George Lucas is managing director of Instreet Investment, a group that builds products for the financial advisor community. “There are two ways of using capital protection,” he says. “The first one is as a tax effective investment at the end of the financial year, where people borrow money to buy a product. The other is using capital protected products in self managed super funds or portfolios as a normal part of the asset allocation. That part of the market is growing, while using it as a geared vehicle for tax effectiveness is diminishing.”

Instreet has developed products that work well for self-managed super funds, and this represents another shift in capital protection: funds for near-retirees who want protection in their super.

In December 2007 Axa launched its Axa North product, modelled on an offering it has been selling in the US for years with some success – it has around US$50 billion under management. The innovation of this product is that it provides capital protection within a super fund. The logistics of a super fund – regular contributions, a need for flexibility and eventually withdrawals, different tax environments at different stages – makes this a quite different capital protected product from the normal stand-alone ones.

Andrew Barnett, head of structured solutions at Axa, says “the dynamics are very different” in a product like this compared to some of the gearing-driven products popular in recent years. “The investor psychology, in terms of the purchase, has a lot more to do with wealth insurance. We see a number of superannuants who are approaching retirement, are 50 to 65 years old, and have accumulated a fairly large asset for retirement. They want to make sure it is not impaired by anything that happens in the markets.”

Lucas also notes that an older investor base has an impact on how funds are structured and sold. “Self managed super funds tend to be for older people – because of the amount of money you need to justify opening one – or people in their pension phase, who are very capital conscious and about to retire in the next five years,” he says. “They don’t want to see huge drawdowns in their capital. The gearing products tend to be used by advisors for a completely different group, 30 to 40 year olds, as a way of accumulating wealth.”

Another shift is in the way these products work. Most capital protected products in recent years have been sold for a six to eight week period, generally around the end of the tax year, and then are closed to new money and locked away. You then have to wait for a fixed term, usually between three and seven years, before the capital protection kicks in and you can take out your money. Both Instreet and Axa, though, have tried to move towards methods of continuous capital protection.

Providers of the traditional gearing-linked products say rumours of their demise are exaggerated. Peter van der Westhuyzen at Macquarie says demand “has been stronger than ever.” The volatility of the last 18 months has focused investor attention on the value of capital protection, he says, and he argues that the protected lending products that come from Macquarie and others do two things: allow investors back into the market with protection against market falls, and also “give the biggest possible exposure to a rebound,” since investors are borrowing money rather than just using their own capital.

“The number of users of protected lending has actually increased year on year quite significantly: about 21% in terms of number of clients,” he says, although the industry protected loan book has stayed pretty steady in terms of overall volume at around A$2.7 billion. Macquarie recently launched its Equity Lever product, which allows investors to buy any of the top 100 ASX-listed shares and leverage up to 50%, with an 8.65% variable interest rate. He calls it “a very clean and very simple way of getting leverage into blue chip Australian shares,” which fits another pattern in the industry: greater simplicity where possible.

THE DARK SIDE

It should be said, though, that not everyone is a fan of the idea of capital protection. Their reputation hasn’t been helped by a couple of events in the last 18 months. Many products provide protection by dividing the funds between the asset you actually wanted to invest in (shares, let’s say) and something safe and dull like a zero-coupon bond. In many cases, when markets get volatile, more and more of the investment is transferred to the bond until in extreme circumstances the whole lot ends up there, meaning you’re stuck for five years or so waiting to get your money back knowing that you no longer have any exposure to the shares you bought the product for in the first place. While that’s exactly what these products are supposed to do in a market crash, it can be annoying for people who are in them, and many products did end up cash-locked like this in the market volatility. Worse, there have been instances – most notably involving UBS and its protected loan into a product from Rubicon – in which the bank providing the guarantee has claimed it no longer applies because the underlying asset (Rubicon’s fund in this case) has been wound up and no longer exists.

“People are a bit more cautious about capital protected products than they have been in the past,” says Paul Moran of Paul Moran Financial Planning in Melbourne. “They are asking manufacturers to justify more and more why does a product need protection, and what is the cost of that protection.”

Planners tend to be suspicious about the very idea of capital protection. “Every asset class, broadly, should have some kind of risk and return characteristics, and the return you get should be on the basis of the risk you’re prepared to take,” says Moran. “Often these are sold on the basis you can get the expected return without taking the expected risk. I have trouble with that concept.”

So does Darren Johns, a certified financial planner at Align Financial on Sydney’s Northern Beaches. “There’s an inherent relationship between risk and return,” he says. “The biggest antidote to risk is time: provided you’ve got time on your side in theory you’ve eroded all risk. These products try to strip out the risk but after fees they can’t deliver the returns investors might expect from taking market risk.”

He also feels this is just the wrong time to be seeking capital protection anyway – the right time was before the market crash when there were gains to be protected, not now when those gains are long gone. “Right now the expected return from the market, whether it’s the All Ords or global shares, is much better than it was 12 or 24 months ago,” says Darren Johns.

Despite the shift to simplicity, Johns says “I still think they’re incredibly over-engineered, with multiple layers of fees. I was looking through a PDF and there were 10 pages on fees, and then another 10 pages on costs. To me, they’re one and the same.”

It’s also important to understand how capital protected lending works. In these products, the manufacturer makes their money on the interest on the loan, which can be pretty steep and well into double digit percentages (see the table inset). The capital guarantee covers your initial loan, but you still have to pay interest on that loan for its duration, so it’s not actually true to say you’ll get all your money back – you’ll get your money minus the interest costs, although there is the tax benefit to consider. Basically, you want to be sure that your return from your investment will be greater than the interest you’re paying, after considering the tax.

Protected lending products have another headache to deal with too. In the May 2008 budget changes were proposed to the level of interest deductibility on protected loans. Historically, the benchmark for deciding deductibility is the personal unsecured lending rate. The budget proposed that it be changed to the housing loans benchmark rate. That’s a big deal: as of June 2009, the unsecured personal loans rate is about 13.5%, and housing loans 5.75%. “The impact of that has been reasonably significant on the capital protected lending industry,” says van der Westhuyzen. “We don’t see investors using capital protected loans as purely a tax investment, but the tax consideration is clearly a component.”

That said, these haven’t become law, and the Treasury has indicated it is prepared to listen to industry before implementing it, so providers are hopeful they can keep things as they are. It’s fair to say if that change does come in, it will badly dent the attraction of protected lending.

On balance then? A capital protected product is a trade-off. For those who want comfort in their investments, they serve a purpose, but remember that nothing comes for free.

SCENARIOS

To give an example of how a capital protected product works under different scenarios, let’s take a look at JP Morgan’s current offering: the ASX 20 growth series. Like many products of its kind, this one involves a loan. You put in $9000, of which $1500 goes to interest; you also get a $22,500 loan, so between the two you’re getting $30,000 of investment.

Also like many products of its kind, this one uses what’s called ‘dynamic synthetic allocation’. That means there are two separate assets, and your investment gets split between the two, with the proportion varying depending on what’s happening in the markets. One is a basket of 20 of Australia’s biggest companies’ shares (from which you also get the dividends); the other is a swap agreement that protects the value of the loan. This means you’ll never be on the hook for that loan, but that your original $9000 is not protected. Depending on market volatility, you’ll have between 20 and 200% of your money committed to those Australian stocks – the 20% minimum ensuring that you never end up cash-locked, which is where everything you have in your investment goes towards the capital protection and nothing towards the shares you wanted to invest in.

It’s a five-year product and you get to lock in half your returns at the end of the third and fourth years.

Aegis has done some modelling on this, showing what would happen to capital growth if the stocks stayed flat, or went up 10, 20 or 25% a year during the investment period, assuming 15% volatility, and compared it to what you’d get if you just owned the shares. With flat or 25% market returns, you’d be better off in the JP Morgan product, coming out with 0.4% and 31.7% per year respectively, in both cases better than buying direct; at 10% growth a year in the stocks you’d come out with a 4.7% return, and for 20% growth, 20.7% return, in both cases worse than if you’d gone in yourself.

Aegis doesn’t calculate, though, what happens if the markets tank in this period. In this instance, while the loan you took on is safe, your original $9000 investment is at risk. In sum, Aegis calculates that the basket needs to grow by 2.8% a year annually to preserve your initial capital once you consider fees and loan interest, as well as dividends and tax deductibility.