More financial planners are advising clients to use capital-protected products in their portfolios as a defence against market volatility, but is this a sound strategy?
The advisers who are moving their clients into capital-protected products are typically doing it for one clear reason: they want to manage downside risk in client portfolios.
“From a planner’s perspective, a capital-protected product provides protection from a downturn and peace of mind,” said Investment Trends chief operating officer Eric Blewitt. “It gives you access to a number of different markets in a protected instrument. The product is a shell and you can put many different assets in, including shares, commodities, specific indices and even physical gold,” Blewitt said.
In very basic terms, a capital-protected product gives the investor exposure to growth assets with the guarantee that the initial capital invested will be returned at the end of an agreed period. The mechanisms used by the product provider to honour that guarantee vary and leverage may be involved.
Capital-protected products actually fell out of favour with investors throughout 2011 – 9% fewer investors used capital protected financial products in the year to December 2011 than the previous year (down from 50,000 investors to 45,500). Inappropriate market conditions were one of the main reasons why investors said they wouldn’t use capital-protected products in their portfolios.
Blewitt said the reputation of capital-protected products became tarnished because some were designed to push the client’s exposure out of growth assets and into cash in the event that markets fell and fell quickly.
“They became cash-logged and the investors couldn’t get their money out until the maturity date, so they sometimes had to sit for three years with no exposure to their chosen growth market at all,” he said.
Executive director of Macquarie Specialist Investment Peter van der Westhuyzen, however, said a lot of those cash-logged products actually did what they were designed to do. “We have numerous examples where if your client had invested directly in equities in 2009 the value of their investments would still be down 30% but those capital-protected products that reverted to cash were only 20-25% down,” he said. “Risk management has become a key part of the advice process in the last three years, both in terms of capital preservation and capital creation. Advisers are aware that term deposits are not going to give adequate returns, so they are looking for ways to give growth exposure without the downside.”
Despite the fall in investor numbers in 2011, the latest Investment Trends capital-protected products report indicates that more financial planners advised their clients to use capital-protected products in 2011 than in 2010 (35%, up from 31%) and more were intending to do so in the next year (14% up from 9%). Some 72% of investors in capital-protected products use a financial planner.
According to Investment Trends analyst King Loong Choi, this says that market performance expectations play a key role in driving and hindering investor appetite for these products. “When we consider that nine out of 10 investors expect the market to grow by only 4% per annum over the next five years, the challenge for the capital-protection market is how to deliver to investors’ needs and provide protection at a reasonable cost,” he said.
Wealth Professional asked Macquarie Specialist Investment’s executive director Peter van der Westhuyzen to address some common criticisms made of capital-protected products using examples from Macquarie’s own stable.
CRITICISM: Capital protected structured products are only open to new investors at particular times of the year, so they don’t allow investors to enter their desired market at a time they choose
PVDW: “The Geared Equities Investment Plus is continuously open, so investors can buy into Australia shares at any time. They own and benefit from the growth, dividends and franking credits.”
CRITICISM: Capital protected products tie up the investor’s money for too long
PVDW: Again, the Macquarie GEI+ allows investors to exit at any time during the investment period, but break costs can apply.”
CRITICISM: The capital protection applies at the maturity date only, so you’re stuck with the investment until that time
PVDW: “The capital protection applies throughout the investment term for both the GEI+ and the Flexi 100 Trust. The whole amount invested in the GEI+ is a limited recourse loan from Macquarie. At the end of the investment period, the client hands back any shares that have gone down in value and keeps any that have gone up. Let’s say their original investment is in four shares, and two go up and two down during the investment term. If each share is initially worth $25,000 and the two poor performers end up valued at $5,000 each, the outstanding part of the $50,000 principal borrowed to pay for those shares is written off and Macquarie receives the $10,000 they’re now worth. The $50,000 principal loan that relates to the shares that have gone up in value has to be paid back and you keep the difference. The loan is, of course, interest only and the client must have the cashflow in place to pay the interest each year.”
CRITICISM: Capital-protected products are expensive
PVDW: “The Macquarie Flexi 100 Trust (which is open to new investors three times per year – the ninth and current offer is open until June) doesn’t have an application fee. Brokerage and advice fees may apply, but the only charge Macquarie applies is the interest rate, which currently sits at 7.95%, on the 100% limited recourse loan. No break fees apply on this product and the investor is given the option to walk away quarterly.”