The catch with capital protection

One can argue whether UBS or Rubicon has served investors less well in this case – Rubicon did not respond to queries from the AFR – but in any event investors who believed they had nothing to lose, are losing.

And this is not a unique case. Another Rubicon fund with a capital protected element to it has also fallen on bad times. Macquarie Bank is currently writing to seven investors to whom it provided loans to invest in the Rubicon Capital Protected Australian Leaders Fund Series 1. The capital protection in this case was provided through a put option. This fund, too, is being wound down, and Macquarie is also asking for its loans back. “We are asking them to close out their loans because hanging on to them would be detrimental as they are paying and accruing interest and not getting any distributions,” says a spokesperson.

The situation in this fund is complicated by the fact that it has already paid back two distributions back to investors, one of 55 cents per unit in October 2007 and the other of 10 cents in April 2008. A final distribution will follow at some point, but Macquarie doesn’t expect it to be more than five cents. Whenever that distribution is made, the units will be cancelled, and if that’s before the 2011 maturity date, the balance of the loan becomes payable and the put option lapses too.  Macquarie has given a couple of repayment options to investors, factoring in the distributions that have already been paid, but investors still look likely to face losses of more than $13,000 on a $50,000 loan. It appears that investors do have the right to do nothing and (if maturity is reached before a final payout) have their capital protection honoured, but in doing so they’ll still be up for the interest on their loan which will have been building up steadily without any gains to offset it.

This brings us to a central point that is worth restating. On capital protected loans, the guarantee (even when honoured in the way investors expect) does not mean you get your original money back. It means you get your money back minus whatever interest has accrued on the loan. And that’s never insignificant:  even with today’s low interest rates, the lowest rate available on a one-year loan according to Infochoice is 16.6% (through Smith Barney), and can go as high as 54.3% (St George). In any investment, you need to be confident of coming out ahead of that interest rate before you get started.

While the UBS situation is new in Australia, elsewhere in the world there have been a number of instances where capital protection has ceased to exist too. So far the most common reason has been where the counterparty that provided the protection has run into trouble – so, for example, if Lehman Brothers was the provider of capital protection on your product, that’s not a whole lot of use since Lehman no longer exists.

The UBS situation is uncommon so far in Australia, where instead the more frequent outcome is that investors find themselves locked into cash for a period of years and lose the opportunity of doing something else with that money (plus the annoyance of watching high-end fees disappear out of it). Macquarie’s ALPS series has been under particular scrutiny, but the situation there is broadly the same as in the Aviva products: there’s not yet any reason to imagine investors will never see their money, they’ll just have to wait for it. “With ALPs, it was clearly identified that the capital protection was only applicable at the end,” says Moran.

Partly, this debate comes down to the role and meaning of PDSs. Darren Johns of Align Financial Planning says that many prospectuses refer to an “extraordinary act” which might prompt a major change in circumstances in the product, to the detriment of investors. “But how do you define an extraordinary act? 99% of financial planners would read that to be acts of war and acts of God, not acts of extreme stupidity, which is partly what this financial crisis is due to.”

“Overengineering of financial products seems to be the undoing of a great many investments,” he says.