The fall in global investment markets has acted as a catalyst for investors to focus on limiting their losses, almost to the extent of ignoring any potential returns they may be able to receive from any assets they had been holding.
Perhaps one of the more graphic illustrations of this trend was the preference many individuals had in the back half of 2008 for simple bank deposits, just so they could take advantage of the guarantee the government issued for these instruments. Such was the magnitude of the flight to cash certain types of investments, such as mortgage funds, found the need to freeze redemptions in order to manage their liquidity requirements.
However, a pure flight to bank deposits may not be the only option available to investors who are looking to limit their downside risk. Structured products such as capital protected products offer the ability to invest in an underlying asset, more often than not a managed fund, while at the same time guaranteeing investors will, as a minimum, redeem their initial outlay in the product.
It is important to note this article will only examine the products offering a guarantee of the investors' original amount invested and not those that involve investment gearing, as they are not applicable in a superannuation environment.
"The primary benefit of these products is to give investors the downside protection of their asset. Quite often they're put in place for the longer-term," Macquarie investment lending head of sales and marketing Peter van der Westhuyzen says.
"In most cases we see people wanting to invest into a capital protected product that gives them exposure to various asset classes over a period of time, so three, five or seven years for example. But during that time they realise markets go on cycles and they want some protection from these cycles, especially if things do change dramatically on the downside."
While these products may seem like a good solution for investors wanting to restrict their losses, it is important investors are clear on the finer details of these offerings. And one of the most important aspects they need to know is what type of mechanism is being used to enable the capital guarantee.
The most common form of protection mechanisms is a technique called Constant Proportion Portfolio Insurance (CPPI). Here the manager sets a floor for the value of the underlying asset and when the asset value approaches it the underlying asset is sold and replaced with an investment in cash or a cash-like financial instrument.
The manager will then not reinvest in the underlying asset until its asset value appreciates and approaches or passes a higher predetermined level.
"CPPI does tend to sell in a falling market, which is one of the behavioural biases that you shouldn't practice. So to some extent CPPI is almost an automated way of dampening your returns if the market then does recover, because you'll be more invested in cash and less invested in the growth asset. We do see that as a shortcoming of the CPPI products," Axa head of structured solutions Andrew Barnett says.
The drop in equity markets over the past six months has provided an acid test for the products and what they aim to achieve and Financial Facts head of research Maggie Callinan says a lot have performed well.
"Many of the CPPI products would have gone to cash in this time and effectively the guarantee has held and they have outperformed the market because they haven't taken the falls. What it has meant is that a lot of the funds are all in cash now," she says.
"They will outperform in a falling market but they will usually underperform in a rising market."
To overcome the possibility of investors completely missing out on returns when the market rebounds, some capital protected products employ a minimum investment level in the underlying asset.
JP Morgan is one manager that offers this feature to its clients with a minimum exposure level of 20 per cent.
"Any CPPI product that we issue has a minimum level of equity so you can never be cash locked. With the more traditional form of CPPI, as you re-leverage and de-leverage effectively you're buying high and selling low and if you do this a lot of times you'll find there's not much left to play with and ultimately you can end up stuck in bonds," JP Morgan equity derivatives and structured products vice president David Jones-Prichard says.
"If we put a minimum level of equity in there, no matter how much you buy high and sell low you're going to end up with some level of participation in the upside if we do see an upside swing."
However, each product differs as to the minimum exposure amount and this is something investors need to assess.
"Some structures will have a minimum exposure, for example specifying you will at least have 5 per cent invested in the market. When it gets down to that level it's actually very difficult for you to actually get significant exposure again," Perpetual general manager structured products Russel Chesler says.
"You'll have some small exposure, but unless you have significant market performance it's not really going to help you because you are just sitting a little bit above that protection floor."
While CPPI is the most commonly used protection mechanism some products do use other techniques. Axa North is one such offering that uses a different protection method that allows clients to remain invested in the underlying asset for the duration of their time in the product, meaning they would not miss out on any of the returns from a market recovery.
"With North once they pay a premium we don't change the underlying assets in which they have invested," Barnett says.
"Our hedging fundamentally is different where we take a premium, and it varies very broadly between 1 and 3 per cent for the guarantee, and then we invest that in futures. So we short futures and enter into interest rate swaps and currency swaps to build up an asset that sits on our own balance sheet, which underpins the guarantee and that asset has an inverse relationship to the client's underlying asset."
A further issue to consider with the protection mechanism used is counterparty risk, as many of the measures involve instruments issued by other financial institutions. Most product manufacturers will ensure they are dealing with reputable organisations in order to mitigate this danger.
"In our products we have used Deutsche Bank and UBS as counterparties and the risk the investor's got is if those banks default at the end of the day just like if they defaulted on a bank deposit," Chesler says.
"I still don't believe that there is much of a risk of that happening with the sort of institutions we've chosen, but that's obviously something investors always need to bear in mind."
Because it doesn't use CPPI to affect the guarantee, Axa's product is able to avoid any counterparty risk.
"In our view there isn't a significant counterparty risk because the instruments we use are exchange traded futures and the counterparty risk on these is really non-existent. For example you have margins held with the exchange," Barnett says.
Most capital protected products have a contract term that is usually for a three- to seven-year period. Individuals in most cases will have to stay invested in the product until maturity in order for the capital guarantee to be applicable.
"Our maturity term is seven years and the reason we set it for seven years is we wanted to make the product as robust as possible to make sure that if you do have a 15 to 20 per cent drop in the market you don't end up in a position where your investment is all sitting in call options," Chesler says.
In some cases when the maturity term is for a longer period, additional features will be offered to investors. For example, Axa offers two products with capital protection. One has a maturity period of five to seven years and offers a standard capital guarantee. The other is more focused on delivering capital growth and has three maturity terms on offer - 10, 15 or 20 years.
The product with the longer maturity term contains an additional feature of being able to lock in any capital gains delivered by the underlying asset. It means the amount guaranteed can be increased during the contract period to reflect and lock in any capital growth already generated by the underlying asset.
While ordinary investors may see the maturity terms as an impediment to their needs, an allocation to capital protected products in a superannuation context can be more suitable as the time horizon of the product and the investment structure make for a better match, according to van der Westhuyzen.
Even though superannuation investment time horizons are normally for a longer period of time, there will still be instances where an early exit from any investment may be necessary. As such, it is important investors know what the consequences are of breaking early from a capital protected product.
"A really important thing to be aware of is the consequences of exiting one of these products early in terms of what break costs would apply and if there are any penalties applicable," van der Westhuyzen says.
Knowing when a product can be exited is another critical detail that needs to be noted and this is usually dependant upon the liquidity levels of the product.
"Some issuers have weekly liquidity, others have six-monthly liquidity, and some issuers have annual liquidity. All of those details are documented in the product disclosure statement," Jones-Prichard says.
"We think liquidity is something which is important, so generally we either provide weekly or monthly liquidity for our clients."
The fees involved with capital protected products will always be greater than a standard managed fund due to the additional mechanism of the capital guarantee.
"The general rule of thumb with capital protection is the more transactional it is with a shorter-term and the more capital protection you want the higher the cost. So putting capital protection into a superannuation investment with a long-term focus can be quite a cost-effective way of either preserving capital or making sure you are exposed to the upside," van der Westhuyzen says.
Despite these products being more expensive, Chesler says the additional cost is not excessive.
"If you take our products for example, the fees for the underlying managed funds are at wholesale rated rather than retail rates. Then we've got an administration fee of 75 basis points and a dynamic management fee of 70 basis points," he says.
"If you compare that to a retail platform, even when you've added in the administration cost and the dynamic management cost, it's not that much more than what they would be paying as a retail investor into a managed fund directly."
Jones-Pritchard says in recent years capital protected products have become more reasonably priced.
"Maybe in years gone by structured products were more expensive, but I think certainly in the last three or four years there has been a really big effort to drive down the costs and that's been driven by product innovation and also a larger number of competitors in the market."
"So the market has been a lot more competitive and as a result the quality of the products have improved but the costs of the products have improved as well," Jones-Pritchard says.
