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Apr 07

Traps of Capital Protected Investments

Capital protected investments are getting more and more popular in these economically uncertain times. There are quite a few varieties of capital protected products and on the surface many of them look very attractive however most come with a few hidden traps. This article doesn’t explain all of the traps but a few of the more common ones.

Some examples include:

  • 100% protection and 100% exposure to growth of the S&P/ASX200 index…this is a very common structure where the protection comes from the purchase of a zero coupon bond and the index exposure comes from the purchase of a call option. The trap is that the exposure is only capital growth and excludes any franked dividends that the S&P/ASX200 may pay. The current dividend yield of the S&P/ASX200 index is around 7.2% and if we assume a significant drop to 5% dividends over the next 12 months plus some franking then this is a hefty price to pay for the pleasure of capital protection.
  • 100% capital protection and 100% exposure to both growth and dividends of an underlying index or managed fund…this particular capital protected product uses an insurance method commonly called CPPI (Constant Proportion Portfolio Insurance) or Dynamic Threshold Management. Basically, if the underlying index or managed fund drops below a certain price, it is sold and low risk bonds are purchased to ensure the capital is protected. There are two traps with this method. Trap One…in very volatile markets and low interest rate environments this method is prone to failure. This is because a sudden drop in the price of the underlying may not given the protection manager sufficient time to sell at the right price to ensure protection. This leads to counterparty risk so ensuring the provider can pay up is essential. Trap Two…this method is inefficient as growth assets are sold when low and bought back when prices are high. This seriously dilutes the final return.
  • 100% Protected Index Linked Deferred Purchase Agreement…there are a few products available at the moment where for a deposit of around $5,000 to $7,000 an investor can obtain a 100% protected exposure to $50,000 in an index such as the S&P/ASX200 with a cap on the upside of between 20% and 30%. There are several traps with this product…
    Trap One…the same as point 1 above applies, that is, the index exposure excludes dividends. Trap Two…the payment is in fact an insurance premium payment and not an installment or actual investment so like any insurance payment it is a cost that is immediately lost. Trap Three…the price. The investor is actually purchasing an “At the money” call option plus selling an “Out of the Money” call option with a strike price 20%-30% above the current index price. Using option pricing methods such as Black & Scholes at current volatility levels this structure should cost around 5%-7% at most but the actual cost is 10%-14% (($5,000 to $7,000)/$50,000)…quite a hefty profit for the product provider and quite a high return required (without dividends) just to get the premium back.

Unfortunately, due to their complexity capital protected investments lack a lot of pricing transparency and in these volatile times cost a lot of money. Always keep in mind that capital protected products are unlikely to replicate sharemarket returns and are expected to provide a diluted return. Due to these factors it is typically more efficient to invest into a balanced portfolio of numerous asset classes.

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