Another Furey View on Capital Protected Investments

Coinciding with reduced sharemarket volatility, capital protected products are reappearing from the usual issuers and are looking a little more attractive than those that appeared leading up to 30 June 2009. Despite this, their lack of transparency around pricing, complexity in terms of the make-up of returns, and their lack of simplicity in explaining their tax treatment create significant risks in managing client expectations.

On the surface, capital protected products appear very attractive…the idea that you can invest for a period of time, have exposure to the potential of growth from sharemarkets whilst getting your money back if it doesn’t work out sounds very attractive. However, many products don’t quite appear to be that simple as the product’s sharemarket returns exclude returns from dividends, or if the sharemarket plummets the investor may be left in cash with no way out even if sharemarkets rebound, or in some extreme cases the protection may not even work.

Three Types
Fundamentally there are only three ways of protecting invested capital whilst providing sharemarket exposure…

In a perfectly rational and normally functioning world, all three methods should yield the same return at the end of the term of the investment. However, when markets behave badly this is not the always the case.

Method 1 – Put Option
Whilst this is the simplest of all methods to price and understand, it is probably the least common method used by structured product issuers…perhaps for these reasons!

The main drivers of price for a put option (or call option) are ‘expected volatility’ of the underlying asst (or sharemarket) and current interest rates. Over the last 20 years the ASX200 Accumulation index has had an average volatility of around 14%pa (I’ll cover this definition another time). Therefore if you insure a portfolio of shares that replicated the ASX200 over a period of 5 years, given 5 year government bond yields of around 5%, this would result in the up-front cost of a put option being approximately 8.1% of the value of the portfolio. If this up-front price was amortised over the 5 year term, the cost would be approximately 1.6% per annum.

So, given these costs, the expected return of a sharked portfolio that is capital protected by a put option should be reduced by around 1.6% per annum of the sharemarket produces a positive return over the 5 years or will produce 0% if there is a negative return.

The main benefit of this method is that the investor receives the full benefit of the sharemarket investments (minus put option costs) for the term of the investment.

The Furey View is that this method is a preferred method of capital protection. The one caveat is that the Put option is provided by a low risk financial institution or clearing house, and that the pricing of the put option is fair and reasonable. That is, given current interest rates, the price does not indicate abnormally high volatility expectations.

Method 2 – Bond and Call Option
As already mentioned, this particular method should provide the same return as method 1. Unfortunately, many issuers tend to mislead investors with a return promise that is not as attractive as it may appear on face value.

A common example of this capital protected investment has the following attributes…
•    5 Year Term
•    100% capital protection at maturity
•    Return at  maturity to be the higher of 100% times the performance of the S&P/ASX200 index or your invested funds back

To many, this appears to be too good to be true as the potential is to receive a return that is higher than the sharemarket (represented by the S&P/ASX200). Unfortunately, it is too good to be true as there is one important factor missing…dividends. The S&P/ASX200 index is not the S&P/ASX200 Accumulation index as it is a price index that excludes the reinvestment of dividends.

For the issuer to create this product, for every $100 invested they will place $79 into a zero coupon bond and the remaining $21 is used to purchase 5 year call options over the S&P/ASX200 with a strike price at the current value (say $100). Current option markets indicate implied volatility of around 20% for the S&P/ASX200 index (this is higher than historic averages) and with interest rates at 5% and an expected annual dividend yield of 4%, this type of call option should cost around 17% of current value (or $17 of the invested $100). In other words, the issuer is taking $4 for every $100 invested. If the expected volatility of the S&P/ASX200 index drops to its historic level of around 14%, then the call option costs around 12.1% and the product issuer profits are almost a staggering 9% of invested dollars. Appropriate pricing of these products is where most risk is often taken on with these types of products.

The benefits of this method include the investor maintaining exposure to the underlying assets at all times during the term of the investment and like Method 1, this is also a preferred method for capital protected products. Once again, it is expected the counterparties to both the bond and call option to be very low-risk and that pricing is fair. Approval will rarely be provided if margins are deemed excessive.

Method 3 – Constant Proportion Portfolio Insurance (CPPI)

CPPI comes under various other names including “Dynamic Threshold Management”, and “Dynamic Asset Allocation” to name a couple. This particular method typically does not rely on the use of derivatives like the first two methods but uses a management team who monitors the price of the underlying risky assets. As the price of the underlying assets decrease, to ensure capital protection the manager sells out of the risky asset and moves the funds into low-risk bonds. The “constant proportion” part of this method is that there is a constant proportion relationship between the amounts in bonds and risky assets  and it is this relationship that ensures capital protection.

There are two main risks with this method which in the view of Research make this method undesirable. Firstly, if the underlying risky asset has a ‘crash’ in market prices, it may not be possible for the CPPI manager to sell sufficient assets to ensure capital protection. As a result, unlike methods 1 and 2, this method is prone to failure in markets that ‘gap’. The best example of this type of market was the 1987 crash. So, just when you need the protection the most, it fails.

The second major risk of this method occurs after market price drop such that all assets are invested in the low risk bonds. Once this occurs the investor then must wait out the remainder of the term knowing the highest return they will receive is zero. Once funds are moved completely to the low risk bonds, exposure to the underlying risky assets is lost and the investor does not participate in any market recovery. This outcome has occurred following the market downturn of 2007 and 2008 where numerous investors in capital protected products, like Macquarie Fusion, are now stuck with their invested dollars stuck in bonds for several more years before they get their original invested funds back. Inflation will reduce the buying power of these invested dollars and if the market rebounds to new highs investors will still miss out.

It is for these two reasons, that the Furey View is such that CPPI and related methods are undesirable.

There are numerous different types of capital protected products available in the market place and whilst they may not appear to be like the examples mentioned above, they will only ever consist of put options, call options, bonds, and management methods. Sometimes derivatives will be sold and sometimes bought. Some products will offer income or even conditional outcomes. At the end of the day the issuer is providing a promise to deliver a return that typically comprises of return based on the performance of a risky asset or a proportion of your money back. Just like a term deposit interest rate promise, the issuer does not have to disclose how much they are making on the transaction…as this is independent to the promised return. Capital Protected products are often loaded with highly priced derivatives that appear quite attractive at face value but at maturity there is often a strong likelihood that the investor will be disappointed with their final return.