The catch with capital protection

Australian Financial Review, February 2009

Aviva has good news. Or so it seems from the letter to investors.  “We are pleased to inform you that the value of your investments in Aviva’s Capital Protected fund(s) remain protected from the recent market downturn,” says the letter, signed by group director of operations Frank Lombardo.

He’s talking about Aviva’s Pre Select 100%+ Capital Protected Australian equities fund, and variations of it, which according to the fund’s 2007 product disclosure statement “aims to provide investors with exposure to Australian shares and cash assets”. But the letter’s punchlines come a few paragraphs later. “We have protected the… fund(s) by fully investing them in cash.” Then: “To protect your investment, the… fund (s) no longer has exposure to Australian shares and will remain invested in cash until maturity.” And finally: “The capital protected value will only be paid to you provided you remain invested until the fund’s maturity date.” And that date? May 31, 2013.

In other words, the equity product investors bought from Aviva in 2007 no longer has any exposure to equities. It’s all in cash. And if investors want that cash back, they’ll have to wait more than four more years. On top of that, the level of capital protected cash is going to drop by 1.2% per year in fees until that maturity date, giving Aviva an equity-style management fee for holding a lot of money in cash.

Let’s be clear: Aviva has done nothing out of step with its PDS, nothing it didn’t warn people from the outset couldn’t happen, and in preserving investors’ capital (minus those fees) it has probably served investors much better than many other structured products. But it reflects a growing trend of investors finding that products they bought into are now doing nothing even remotely resembling what they bought them for.

Additionally, a much more worrying event has given investors real doubts about whether they should ever trust capital protection at all. In 2006, Rubicon Asset Management launched a fund called the Rubicon International Leaders Fund, including a capital protected version. The idea of this fund was to give investors access to a range of absolute return managers (sometimes called hedge funds) which ordinary investors would ordinarily not be able to get access to. The fund, advised by hedge fund specialists Tiedemann Trust Company and approved by independent researchers such as Aegis, had A$15.7 million in it as of September 2008 – the last update the fund would publish.

It’s no secret that many hedge fund managers have hit terrible times, and by September last year the fund was being hit, which in turn triggered a clause at UBS (which was providing the capital protection) that made it demand redemptions. The fund ended up with exposure only to a host of illiquid managers, and Rubicon set about winding down the fund.

But people have capital protection, right? Well, apparently not. In a move that has alarmed financial planners, UBS, which had given many of its clients loans to invest in the Rubicon fund, has announced that capital protection won’t apply in this case, because the fund hasn’t just lost value, it has ceased to exist. UBS argues that the prospectus clearly stated that capital protection only applied at maturity (2015 in this case) and that since the fund is not now ever going to reach maturity, protection has lapsed. What’s more, UBS has also demanded a break fee for the early termination of the loans – 9.3% of the original loan amounts.

Many planners are alarmed by this. “The UBS issue has thrown a real spanner in the works,” says Paul Moran, a financial planner at Paul Moran Financial Planning, part of Cameron Walshe. “What has never been raised at any of the BDM meetings [business development manager, in which product developers pitch products to financial planners] is that if the investment doesn’t exist at the end, the capital protection doesn’t exist either. This will be throwing a bit of fear through people who have recommended these products.”

UBS’s take on this is as follows. ”The early termination of [the Rubicon fund] stemmed from a very specific set of circumstances,” says a spokesperson. The portfolio of assets that the fund was linked to “had suffered due to the global financial crisis. Portfolio diversification became difficult to maintain and the asset portfolio became illiquid. This led Rubicon to suspend redemptions from the asset portfolio and commence liquidation of the assets.” The fund was then wound up. “UBS provided loans to some investors in [the fund] and after those investors were notified by Rubicon that their fund was being wound up UBS provided various loan repayment options to its borrowers to unwind their loan over the period in which their investment… is expected to be liquidated.”