Reducing portfolio volatility through guaranteed investments and structured products.
We are at a point in time where there is undeniably market and economic uncertainty. In the various, and many, exposures we have to the asset management industry there is a large divergence in views, supporting the aforementioned statement. Added to this, investment norms have been turned on their head; I attended a presentation a short while ago where it was being described that some managers are investing in bonds for capital growth and shares for yield. In a normal environment bonds are held to enjoy their yield (coupons) and shares are held to enjoy capital growth coupled with a dividend (that is traditionally much lower than bond yields).
Diversification is often described as the solution to overcome volatility, a theory that we strongly support. When we think of diversification we most often turn our attention to asset class (cash, bonds, property, shares), geography and currency. An area that is often excluded is that of diversified pay-off profiles; assets that may have guaranteed returns, capital guarantees, enhanced returns or a combination of these.
There are two investment types I would like to discuss that incorporate non-traditional pay-off profiles. The first of these, and something that has been available for some time, is guaranteed investments. These investments give you a guaranteed return over a five-year term where the growth is either capitalised to maturity or paid out at predetermined intervals during the term. Some things to look out for when incorporating this type of investment are:
- Limited liquidity during the term
- The issuer must be in a good financial position; you must be comfortable that your capital and growth can be returned over the period
- It is usually beneficial to invest when expectations are for long term rates to rise as you will capture this in the current rate on offer. When rates are expected to increase the long term rates are higher (steeper yield curve) and you can buy that rate now. When the market expects rates to decrease the yield curve flattens and you may not get as big a premium for locking in long term rates.
- The quoted returns are typically after tax; this must be assessed fairly against alternatives like a fixed deposit. You should also judge the potential return against inflation and your portfolio return objectives. At the time of writing this article guaranteed rates, with no income, are approximately 7.25% per annum (about 1% less than available 2 or so months ago). This represents a return of inflation plus 1.25% and an equivalent interest rate of 12.28% for a marginal tax payer.
The second type of investment and one that has become more popular, relevant and accessible is a structured product. A structured product is an investment that, in most instances, has a set of predefined characteristics usually including a guarantee of some sort. An example of this may be:
- Three-and-a-half-year term (predefined)
- Capital guarantee in GBP (predefined)
- Reference asset: MSCI World Index (performance unknown)
- Two times upside i.e. for every 1 % up you get 2% (predefined)
- Performance cap of 25% total return (predefined)
- 4% guaranteed annual return in GBP (predefined)
This type of investment gives investors market exposure but with a reasonable degree of certainty around the possible outcomes. Like a guaranteed investment we have a known minimum return but there is also potential upside beyond the minimum; this trajectory is rather different to a traditional investment. There is huge choice around term, currency, reference asset and downside when it comes to structured products. In its simplest form a structured product is made up of two components:
- Zero-coupon-bond: this is akin to a fixed deposit and provides the guarantee
- Derivatives: these provide the potential growth beyond any guaranteed return
To explain the above points practically let us assume a GBP100 investment with the product terms described above. Of the GBP100 to spend, GBP75 may be spent on buying the capital guarantee (GBP75 invested now will, for sake of our example, mature at GBP100 in 3.5 years’ time) and then assume there are GBP5 of costs over the term. This leaves GBP20 to buy the market exposure; if each option cost’s GBP10 then two options can be bought and thus the 2 x upside.
Please take, at least, the following points in to consideration when assessing a structured product:
- Like a traditional (fixed return) guaranteed investment the credit quality of the issuers is very important. You need to have high degree of comfort that the issuers can meet their obligations to pay back the prescribed capital and the upside
- Typically, you do not get the dividends from the reference asset
- Understand the costs; these are usually borne upfront, although over the period of the term work out to be a similar (or in some instances lower) cost than traditional investment funds.
- Invest for economic sense and not due to good marketing.
- There is often liquidity during the term but the value pre-maturity is the market value and any guarantees fall away.
There is a debate to be had in so far as holding the reference asset for a long term (perhaps excess of 10 years) will yield a better result largely due to the dividend cash flow. The lengthy nature of this subject demands more attention and is thus the content for another article. We believe that having a limited exposure to structured products in a broader portfolio is often, when done for the correct reasons, a good idea. The inclusion of these assets blends traditional and non-traditional pay-off profiles and can reduce volatility.
With both guaranteed investments and structured products please take a considered approach when investing and always understand not only how you can make money but perhaps more importantly how you could lose money. These products are primarily designed to provide capital protection with less additional risk in your portfolio.