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Gateway: Enter with caution - Eureka Report article

June 2, 2008
Gateway: Enter with caution
By Scott Francis

PORTFOLIO POINT: A capital guarantee makes products more attractive to "volatility shy" investors. Macquarie's MQ Gateway has such a guarantee but is very complex.

Recent sharemarket volatility provides an opportunity for the marketing divisions of managed investments to add a capital guarantee to an investment opportunity, to give it the appearance of being much more attractive to "volatility shy" investors. However, the addition of such a guarantee makes any investment product more complex and often more expensive, so investors should understand what is under the microscope before they commit.

Recent so-called "structured" Macquarie products have not produced great results for investors. Investments in the ALPS 1 series have seen a number of knockout events that have reduced the initial yield (see Knockouts floor MacBank fund), with the entire first series of the ALPS 1 investments now paying a yield of 0% until maturity.

The Macquarie Fortress Notes were a geared portfolio of debt securities. They had a listing value of $1 and now trade on the ASX for less than a quarter of that.

So what is the Macquarie MQ Gateway investment offer, and how is it structured?

The capital guarantee

The key marketing theme of the offer is the capital guarantee at maturity - in 3.75 years. In other words, when you invest in this product whatever else happens you have a guarantee that Macquarie will give you back all the money you initially invested in the product in 3.75 years. Now, a capital guarantee looks very enticing in this volatile market, but the question is: What is it really worth? In an environment where cash interest rates are 7%, a cash investment will provide a return of just under 29% over the next 3.75 years (assuming the cash rate stays where it is). Therefore, a capital guarantee only guarantees a return that is 29% less than the return that money would receive if it was invested in a cash account.

The investment is very much a "capital growth" investment, with investors not expected to receive any distributions over the investment term. Naturally this will not suit investors who prefer income-paying investments.

Exposure investments

The underlying "investment" of MQ Gateway is exposure to one of a number of investment 'baskets', including:
  • An Emerging Market Infrastructure Trust.
  • Asian Markets though two different strategies.
  • Climate Change.
  • Agriculture.

These investments are referred to as the "exposure investments", which drive the return above the capital-guaranteed level.

There are three underlying components to the fund that an investor must understand, being a "swap", a "put option" and a "deposit", all of which are transacted with Macquarie.

While most investors would understand what a deposit is, the "put" and "swap" may be less familiar. A put option is the "right but not the obligation to sell an investment at a certain price". It is used to put a floor under the value of an investment. For example, if I had Commonwealth Bank shares I might buy a put option so that I could sell then at a known price in the future - in the case that their value fell.

The swap is an agreement between Macquarie Bank and the fund, and is best outlined in page 49 of the Product Disclosure Statement, where it is said that "the swap offers the class portfolio a gain or loss . in return for the fund paying Macquarie interest periodically during the return. In effect, the swap is the "deal" between Macquarie Bank and the fund that enables it to make money in the markets.

It is the put option and deposit that provide the capital protection for the fund, and the swap agreement that provides the potential investment return.

Clearly there are more "moving parts" than a simply managed fund that holds a portfolio of liquid investments, like shares, the value of which dictates the return unit price for investors on a daily basis.

The Product Disclosure Statement (click here to request a copy) outlines a key risk of Macquarie's role in these arrangements, the "counterparty risk". This is the risk that Macquarie collapses, with the PDS noting that if Macquarie did become insolvent that potentially made "the capital protection feature of the investment, and the value of the exposure investments, potentially worthless". The prospect of Macquarie becoming insolvent is obviously very unlikely, but legally this caveat is important because investors would become unsecured creditors if that occurred.

The calculation of the returns for investors at maturity is a reasonably complex process, certainly when compared to traditional investments. Having read this part of the product disclosure section three times, I still struggle to understand it. There is a process whereby a "floored price" for the reference basket is calculated, and a calculation using "quarterly averaging dates" of the reference basket is used in the final performance calculation. This is a key driver of the returns an investor receives, and should be understood before investing. The best investors always say you should understand everything in which you invest. I don't understand this product. I won't be recommending it.