Capital protected products will survive financial crisis

JUST as any other investment vehicle in the current climate, capital protected products are under scrutiny. But as with Mark Twain, reports of their death are being greatly exaggerated, and for astute investors they can play a critical role in helping meet their investment goals.

In particular, many people use these products in their portfolio construction, encouraged by the fact they provide capital protection, which limits the loss in falling markets, and offer access to markets and investment themes that typically cannot be accessed through the stock market.

Capital protected products have been associated with the structured collateralised debt obligations (CDOs) products that attracted local government, hospitals, universities and other public institutions. In New South Wales alone, a report has found councils have a combined exposure to CDOs of $1 billion, of which some were with the collapsed investment bank Lehman Brothers.

As a consequence, these products have been labelled ‘intricate’ and ‘risky’ because of their use of asset classes outside the traditional bonds, property, and equities.

It’s an unfair description. Rather, they should be viewed as a package that combines many parts an investor should look at — tactical asset allocation, sensible leverage and tax efficiency — into one package, a capital protected product, and now are performing in line with expectations in the current volatile market conditions.

But, in today’s far more sober investment environment, where commonsense suggests capital protected products should be thriving, there are some question marks.

Principally, there are two issues putting these products under a cloud.

Firstly, investors are even wary of the institutions (typically banks) that stand behind the fund manager offering the capital protected product. Counter-party credit risk cannot be discounted.

There can be no doubt that the collapse of investment banks such as Lehman Brothers has severely dented investor confidence.

Secondly, the current large and unpredictable volatile moves down, combined with sharp movements in interest rates, have affected the participation rate in existing capital

protected products.

That said these products are still achieving their key goal — protecting your capital — but the cost is a low participation rate to the underlying market. However, many are currently outperforming their underlying markets.

Capital protected products have varying degrees of risk, just like any investment. The common thread is the protection of capital.

For the cautious investor, low-risk capital protected products are almost akin to a fixed deposit. But as the risk curve grows so does the opportunity for the investor to earn a higher return, while always knowing their capital is protected.

But before investors throw the baby out with the bathwater, it’s time to take a deep breath and consider what capital protected products still offer, especially for portfolio construction.

They still give investors the opportunity to gain exposure to investment themes with reduced downside volatility and can also add leverage to a portfolio without having to face margin calls. This enables an investor to gain the necessary exposure to markets, to achieve their goals, without having to significantly rebalance their portfolios.

Margin lending as a wealth accumulation tool will be re-thought, and its replacement may be capital-protected lending strategies.

Protected lending can be expensive compared with margin lending, but the piece of mind that it provides will be a big component of delivering investment strategies to clients going forward.

Choosing the right investment theme while having capital protection is an attractive option for investors. They might believe that certain commodities, such as iron ore and coal in the wake of the industrial revolutions occurring in China and India, offer long-term value, but are wary of the downside risk of investing in stocks that are exposed to these markets.

A capital protected product can offer them the security of locking in their capital while giving them exposure to an asset class they believe has upside.

These products can also offer the potential for distributions, profit lock-ins and capital growth, while, at the same time, offering capital protection.

The industry is actively listening to the financial adviser and investor and improving on their offerings, increasing transparency and liquidity. Products can also minimise any foreign exchange risk via daily hedging mechanisms.

Well-designed capital protected products have outperformed their underlying share markets over the past 12 months.

Investors do value capital protection and as long as the protection is robust, these products will continue to be enjoyed for the wealth creation and control they deliver.

What individuals have to do with these products is no different to any other investment class. They have to choose the product that blends their individual needs and goals with their investment philosophy and, for individuals either nearing or in retirement, in particular, this could still prove to be a capital protected product.

George Lucas is the managing director of the boutique asset manager Instreet Investment.