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Financial Happenings Blog
Sunday, November 15 2009

With the experiences of 2008 and early 2009 still fresh in our memories, it is no wonder that investors are looking hard at the attractiveness of capital guaranteed investments which promise that worse case scenario you will get your money back when investing in riskier asset classes.

Unfortunately there are no free lunches in the investment world - if there was you would have to seriously question the validity of the returns - just ask the investors in Bernie Madoff's ponzi scheme rip off.  Capital guaranteed products sound great but you need to carefully dissect the terms and conditions to know what you are really getting.  The key concerns for me are:

  • costs - providers are well known to take large percentage fees out of your returns
  • third party (counter party) risk - the risk that the party that is providing the guaranteeing will be there when you need them
  • "knock out" events" - investments perform so poorly that your investment is effectively locked into assets that will get you your money back but no more even if investment markets improve

Jim Parker from Dimensional explains these issues in a little more detail in his latest Outsid ethe Flags posting which I have copied below.

Scott Keefer

This Year's Model

A financial market trend is like those in fashion. By the time you latch onto one, the world has usually moved on. And if you act on it, you just end up with expensive stuff that doesn't suit you and that no-one wants to buy.

A couple of years ago, the big trend on the catwalks of the fixed interest markets were exotic numbers like collateralised debt obligations, hybrids and other fancy instruments that were sold to investors as "high yield". Well, we know how that one turned out.

Trying to sell someone those funky fixed interest products in 2009 is like trying to clear a fashion warehouse full of leg warmers, stonewashed jeans and parachute pants. For sure, someone, somewhere once liked this stuff. Trouble is no-one now, apart from '80s revivalists, can remember why.

The fashion industry survives by exploiting a desire in consumers for certain "looks" based on what the rich and famous are wearing. By the time products based on this look hit the mass market, they are no longer fashionable. This guarantees continued turnover.

Likewise, much of the financial services industry profits by making products that cater to whatever emotion investors are feeling at any one time. When those products no longer fit the zeitgeist, a new set is rolled out.

Two or three years ago, with investors focused more on return than risk, the industry had a ready-made market for complex products whose attractive yield was achieved through often hidden levels of credit risk and leverage.

As the Reserve Bank of Australia noted at the time, a long period of low interest rates and relative economic stability had lulled many investors and sent them exploring remote territories in the search for yield.1

The consequences of that lack of attendance to risk, not just by ordinary investors but by major financial institutions that should have known better, were seen last year in the global financial crisis.

Scarred by that experience, many people have now swung in the other direction and are more focused on risk than return. So the financial services industry has obliged by creating products that appeal to that need.

These include new types of structured products that guarantee your investments against loss for a specified number of years. Additionally, there are products that lock in any capital growth you achieve for specific terms.

The marketing line for these "capital guaranteed" products is that investors can get exposure to higher return assets without the associated risk. After the crisis of 2008, this sounds particularly appealing and is an easy sell.

But just as people three years ago were buying structured products not fully aware of the risks they were taking, are they now buying structured products not fully aware of the fees they are paying?

In one such product currently being promoted on the Australian market, the annual fees for the most expensive option are said to be as high as 9 per cent.2 This includes contribution fees, administration fees, manager fees, advisor fees and guarantee fees. That is one expensive insurance policy.

Bear in mind, also, that many of these products are guaranteed only at maturity. If you sell at a loss before the agreed maturity date, you lose your capital protection. In the meantime, you have paid all those fees for nothing and inflation has eaten into the purchasing power of your original investment.

And no investment can ever be truly guaranteed. Even the promoters of these schemes admit that they cannot predict what rates of return will be achieved. As well, investors are exposed to the financial soundness of the organisation issuing the guarantee and the risk that the guarantee will be terminated.

Most of all, there is the question as to whether investors really understand what they are investing in. In some cases, the conditions are such that the "guarantee" is not as solid as it appears.

One Australian investment bank offered a capital guaranteed structured product that offered headline rates of return of 12 per cent or more by investing in equity derivatives. But this was conditional on there not being a number of "knock-out" events. When these occurred, investors were left locked up in a very expensive six-year savings account that paid no interest.3

In Britain in the past month, three providers of capital guaranteed structured products have been placed into administration. In one case, investors in the scheme had exposure to complex products backed by the now defunct US investment bank, Lehman Brothers.4

Even when the investments are understood, there is still the question of cost. Research by the UK's Department of Work and Pensions last year found guaranteed products were "too expensive to be attractive to most people".5

In the final analysis, it is completely understandable after the events of 2008 that investors worried about the return of their capital would be searching for products that give them greater peace of mind.

But this need has to balanced against cost of the products, the lack of liquidity, the multiple conditions, the lack of transparency around the underlying investments and the fact that nothing ever can truly be guaranteed.

An alternative approach is to maintain a diversified pool of assets (cash, fixed interest, listed property and small, large and value stocks in local, developed and emerging markets) commensurate with your own risk appetite.

These investments should be in a low-fee managed fund that controls risk through broad diversification, is mindful of costs and taxes and that seeks to tap the long-term returns of various assets in a transparent, disciplined way.

Those investors who are older, particularly risk averse or anxious to preserve their balances can opt for more defensive portfolios with a greater proportion of assets in cash and high quality, short-term fixed interest.

This is a very straight-laced, some might say boring, approach. But it's effective, easy to understand, low cost and it never goes out of fashion.

1Stevens, Glenn, 'Risk and the Financial System', Reserve Bank of Australia, March 2006.

2Dunn, James, 'Invest in What You Understand', The Australian, Oct 14, 2009

3Kavanagh, John, 'Defying Gravity', The Sydney Morning Herald, Oct 14, 2009

4Vincent, Matthew, 'Arc Capital & Income Placed Into Administration', The Financial Times, Oct 26, 2009

5McArthy, David, 'Investment Guarantees for Personal Accounts', UK Department of Work and Pensions, Working Paper no 62, May, 2009

Posted by: Scott Keefer AT 08:50 am   |  Permalink   |  Email
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