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Page last updated Thursday, 11 March 2010
Managed Investments Bulletin - Issue 53: March 2010
The biggest debate in financial services is whether or not capital protection is justified, or needed. The “justification” point relates to what the asset consultants (ie those that guide portfolio construction by wholesale fund managers) think is the best way to manage risk. The “need” point relates to what end investors think is important to their own portfolio. The debate plays out like this: most traditional asset consultants still think that a diversified portfolio held for a long enough period of time will provide its own set of checks and balances, giving the “optimal” mix of risk and return.
Asset consultants tell us that such a portfolio will experience a negative return only “once in a rolling seven year period”. (Thoughtful investors are quick to point out that the real world isn’t one of “rolling” investment returns)! On the other hand, research conducted for AMP Capital prior to the GFC indicated that capital protection was in the top 3 items sought by SMSF trustees; post the GFC the data is that over 60% of financial planners rated capital protection as the top item sought by their clients. Massive inflows to expensive capital protected products like AXA North (which now has over $700m under its protection) tell us that investors are prepared to pay for protection. Let’s look at how capital protection is provided, what are its costs, and risks.
Since the Australian share market has now experienced two events of -50% performance in a decade, it’s not only investors that worry about capital protection. Protection costs have risen since the GFC, as product issuers’ costs of hedging rise. There are only 4 ways to provide capital protection:
Unfortunately it is hard to rate or understand capital protected products. This sad state actually applies to most investment products – the problem is that typical research houses use a scorecard where 80% of a product rating relates to “people, systems and processes” rather than the hard merits of the investment itself. This means that inferior or risky products issued by fund managers that have been around for a while and have good systems, will end up with a high rating – think back to the high ratings that Basis Capital received, or to the “award winning” status that pedestrian managed funds like Colonial First State receive. You can access some broad information about capital protected products from the educational site www.LPAConline.com.au, or you can read my weekly product reviews on the Eureka Report www.eurekareport.com.au.
Here are some brief snapshots of typical capital protected products:
AXA North offers some attractive investment features. It does not use the “CPPI” protection method and so it remains fully exposed to the underlying investments for its full term – this means that as markets rise after falling, the investment returns can recover also (in CPPI products this often isn’t possible, as they enter into “cashlock” after severe market downturns). AXA North can be invested in without the capital guarantee (in which case it is just an expensive administration platform) or the “Protected Investment Guarantee” (with a 5 or 7 year term) or the “Protected Growth Guarantee” (with a 10, 15 or 20 year term) can be selected. The “Protected Growth Guarantee” facility offers annual profit lock in, ie each year there is a gain above the invested amount, that gain will be locked in (even if the asset falls in value subsequently). See http://axaguarantee.com.au/.
There is a choice of 40 different managed funds within the AXA North protected facilities. Many of these funds are “mainstream” and suffer from the travails of traditional active management. Investors need to keep a spread of funds across different asset classes and there is some flexibility to re balance or change allocations.
The capital guarantee does not cover the upfront or ongoing fees paid to financial advisers. And it’s the potential for massive fees and charges across the entire AXA North product that will, in practice, make the facility unattractive for well informed investors:
Instead of succumbing to annual fees of up to 9.15% pa and hefty upfronts, investors could instead deposit the same amount into a cash account over the same time frame, with the balance invested in either the same managed funds or even better performing direct equities, giving themselves the prospect of significant outperformance with capital preservation even in volatile markets. No wonder AXA North was placed on review by Standard and Poor’s earlier this year – which makes one wonder how it’s possible for some of the other industry research houses to have given AXA North high ratings and “product of the year” awards.
Like the newer forms of ASX listed Instalments, Macquarie’s Equity Lever provides leverage suitable for use by SMSF’s, up to 50% LVR, with relatively low cost interest rates (currently 8.65% pa). The technology used involves the “limited recourse” loan that the SIS Act allows for, meaning that investors can choose whether to repay the loan or to walk away instead. Payment of the loan happens by way of the investor making payment of a “final instalment.” If the investor walks away, Macquarie only has recourse to the specific assets that have been purchased with the Equity Lever facility. The investor’s other assets aren’t able to be accessed by the lender – and that is one of the significant and real benefits that the Macquarie product provides (in the same way as ASX listed Instalments). http://personal.macquarie.com.au/lending/smsf/equity-lever.htm .
Like the newer ASX listed Instalments, Equity Lever does not contain expensive, embedded “put” option protection. Instead, the issuer protects itself from the risk that they will be left holding potentially worthless securities by involving an “Instalment Acceleration Event” mechanism. Initial LVR’s are set at around 50% and there is a maximum LVR of 65%. Equity Lever is available over a wide range of blue chip ASX shares. If share prices fall such that the overall facility LVR reaches 65%, this triggers an “Instalment Acceleration Event”, which effectively acts like a margin call. So like the newer ASX listed instalments which include this feature, investors need to be aware that in falling markets they can be required to make cash payments to reduce the gearing levels below the maximum permitted. This is obviously a real risk in falling markets – as many margin loan investors experienced last year. Prudent gearing levels are a good weapon against this event occurring, as well as ensuring that suitable cash levels are maintained to cover the risk of an “Instalment Acceleration Event”.
But unlike the newer ASX listed Instalments, the Macquarie Equity Lever works on a “whole of secured portfolio” approach. That is, if an investor doesn’t pay in the event of an “Instalment Acceleration Event”, Macquarie can choose which shares it will sell down to cover this quasi margin call. In practice this means that “good” shares may be forced into sale, to cover losses on weaker stocks. This is very similar to the problems experienced last year when margin lenders (and worst still, stock lending based loan providers) sold down quality stocks to cover losses on the rest of the client portfolio. Whilst it’s clear the Macquarie Equity Lever product does not involve stock lending – and that the risk in the event of an “Instalment Acceleration Event” is very similar to that involved in normal margin lending – the Macquarie product does not provide the same level of risk minimization that single stock, ASX listed instalments provide.
Equity Lever has some great features, including good interest rates and automatic repatriation of dividends to reduce the size of the loan within the investment, but in a rapidly falling market it exposes investors to risks that can be avoided by using some of the newer forms of ASX listed Instalments.
It’s sad but true that much of the distress caused by buying shares using home equity or margin lending (a la Storm Financial) could easily have been avoided by using protected investments or protected loans. With memories of the GFC still very fresh, the majority of Australians are still sidelined from the sharemarket, and with little cash to spare, even the brave are often unable to find the funds to buy shares.
Enter CBA’s innovative Capital Series investments, which has a new “Compass” series open for investment until mid June this year (http://www.commbank.com.au/corporate/financial-markets/structured-investments/capital-series/default.aspx). Compass is perhaps the cleanest and simplest capital protected investment currently available to Australian investors, and it comes with gearing facilities which offer attractive interest rates. CBA frequently issues new series of these products, with a variety of different underlying assets. Compass Strategy 1 provides a 5.5 year exposure to the ASX 200 with 100% capital protection, up to 100% investment finance, and potential for up to 3% coupons paid annually after 18 months. Strategy 2 provides 5.5 year exposure to a blend of the ASX 200 as well as the Hang Seng Index, with 80% capital protection, no coupon potential and up to 80% investment finance.
CBA Compass is for cash poor investors looking to get into the market, with the security of capital protection for the wary. But how well will it perform these tasks? Like with any investment, the devil is in the detail – and as anyone who has watched the failures of many forms of structured investment over the last 18 months will be aware, there is a lot of detail to contend with in these products.
Compass uses very simple risk management technology, with investors issued a “deferred purchase agreement” which is a security for Corporations Law purposes. Retail investors and SMSF’s can buy DPA’s. Under this DPA, the final value of Compass is delivered in the form of SPYDRS (ie ASX Index Funds), which investors can elect to sell and receive cash if they wish (why CBA charges brokerage of 0.55% on this sale is puzzling – that sale can be effected by CBA at wholesale rates of 0% and many DPA issuers now waive brokerage on the share sale facility). This DPA is risk managed by CBA which buys “zero coupon bonds” which will mature at the capital protected value, and invests the remainder of the product’s proceeds in call options over the underlying assets (in this case, the ASX 200 and/or the Hang Seng Index).
This technology completely avoids the problems of “cashlock” which plague capital protected products using “CPPI” technology – so the investor’s returns over the life of the product will cleanly track the performance of the indices. Because of the relative expense of these options, the capital growth in Strategy 1 (ASX 200) is capped at 170% and so investors may wish to exit early if this level is reached. Some break costs will be incurred. Overall, fees and CBA profit margin are reasonable.
The tax opinion in the PDS is clear but limited in key areas such as deductibility of interest for geared investors. ASIC should insist that tax opinions can’t hide behind the usual statements that “investor’s should take their own advice.” It’s not likely that investors can get full deductions for their interest costs on either Strategy 1 or 2, and they will not be able to claim deductions upfront either. CGT is payable at the maturity of Compass, which means typical investors will be forced to sell some of their proceeds to cover their tax bill.
Traditional investment management assumes that markets behave with stability and predictability over the long term. There are lots of reasons to assume this is true but the creeping reality is that the massively integrated global markets, fuelled by massive amounts of money with sophisticated trading systems, is still a victim of the greed and fear embedded in the human psyche. Bubbles inevitably form and with rising geo political instability compounding uncertainty, it’s inevitable that markets will continue to be volatile.
At the bottom of the GFC, the prices of all assets were 100% correlated – making a mockery of the idea (central to modern portfolio theory) that diversification is the primary source of protection against risk. Capital protection is rapidly becoming the biggest game in town – and rightly so. Just be careful in how you choose the protected product that is suitable for you.
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