Richard Weatherhead examines the different approaches taken by fund managers to preserve investor capital.
The fall in asset values and the negative investment returns following the global financial crisis (GFC) have made many investors risk averse. There has been a flight away from equities into cash and short-term investment options. In response to this, many superannuation funds and life insurers have been reviewing their product strategies with a view to introducing a degree of protection for investors in the event of further falls in investment markets. Meanwhile, investors appear to be moving back into growth assets; so now is probably a good time to consider the range of protected investment products available in the market and potential developments over the next 12 months. The original protected investment products were capital guaranteed products provided by life companies. They invested in growth assets and provided the protection, or “capital guarantee”, by holding large amounts of capital against their liabilities. These products have now largely disappeared, in part due to the high cost of the capital required. The table below gives a summary of some of the protected products currently available or offered over the past twelve months. The designs are quite diverse. Most are designed as non-superannuation investments but some may be accessed via superannuation products. For example, AXA North is available either inside or outside superannuation.
Macquarie Fusion is packaged with an investment loan with downside protection, targeting those who have geared their investment into growth assets. Each product is aimed at investors with slightly different investment objectives – but the common theme is the desire for protection of the initial investment plus the ability to lock in positive investment returns in the future. Most products have a guarantee term of five to seven years, although AXA North Protected Growth has a 20-year guarantee option. Five to seven years may be in line with the planning horizons of many investors, although, for long-term investors such as new retirees, it means that further financial advice regarding reinvestment options is likely to be required at the end of the initial guarantee term. The consequences of withdrawing early from the product are sometimes not fully appreciated.
For most products the guarantee is lost on early withdrawal, so the customer should invest only the amount they are confident they will not need to access until the end of the guarantee term. Again, the exception is AXA North under which the guarantee increases progressively over the guarantee term. Restrictions on withdrawals make it vital that the customer has access to a good range of investment options and managers on the platform concerned. If there is only a single investment manager and the guarantee is lost on withdrawal, the only way to switch to a different manager, if the customer is not satisfied with their original choice, is to withdraw and lose the guarantee. Fees are also an important consideration. The table shows, for the selected products, the fees charged for the guarantee – but these are in addition to the usual administration and investment management fees.
Obviously, guarantee fees gradually erode the balance available in the long term. If overall fees are too high, then the net return for the customer may be little different from a cash return, which is effectively guaranteed. So, conversations with clients about risk versus returns are important to ensure that there is a real perceived benefit from investing in the protected product rather than a cash or short-term investment option. Most market analysts would expect a balanced investment option to outperform cash by a margin of between 2 per cent and 3.5 per cent before tax, depending on the asset mix. This suggests that additional investment management and guarantee fees under a protected growth product need to be well within this limit for this strategy to be worthwhile in the long term. The methodology used to provide the protection is important in the overall investment decision.
There are two broad methodologies: • The use of hedging alone; and • Progressive switching to cash or call options as markets decline, and vice versa (for example, Perpetual, Macquarie and Navigator in the table). The risk management processes and governance surrounding hedge strategies can be assessed during the due diligence review of the product. However, progressive switching strategies are not favoured by some investment professionals as there is a danger that growth assets may be sold (as markets decline) just at the time when market conditions are about to recover and a switch to growth assets is considered a sound strategy. Similar arguments can be mounted regarding call option strategies. The discussion above, in itself, demonstrates the complexity of many of the protected investment products currently available in the market. This means that professional advice is critical to making the right investment decision in this area.
However, there are real potential benefits for many customers who choose to seek that assistance. Many wealth managers and superannuation funds are currently considering new product developments in the area of protected investments. For example, the growing retirement market combined with increasing longevity has focused attention on products that can complement account based pensions by providing a guaranteed income for life, even after the account balance is extinguished through pension withdrawals and market movements. We can expect to see the launch of some innovative new products in this area over the next 12 months. In summary, protected investment products have a valuable place in the product “armoury” and the range of products available looks set to increase as more wealth managers look to capture a slice of this growing market. However, most clients need professional advice to ensure that:
• They choose the guarantee design that best suits their needs;
• They understand the cost benefit trade-off;
• They understand the potential loss of the guarantee on withdrawal;
• They choose a product with a range of underlying funds and managers that is broad enough to meet their potential desire to switch funds over time while maintaining their guarantee.
