We have seen some significant falls in the sharemarket over the last 18 months. Increase in investor anxiety over equity investments has in turn seen a huge rise in the demand for capital protected and capital guaranteed products.

This issue’s Back to Basics considers whether now is the time to look for capital protection within your portfolio and what are the differences in the structures currently available?

One of Warren Buffett’s most famous quotes is “Invest and seek out opportunities when there’s blood on the streets”. Well, over the last year our streets have turned red, so on that basis, shouldn’t you be filling your boots? Why pay for downside protection when logic dictates that prices are low? Some would argue that capital protection should be bought in times of a booming economy not after the fact...

Herein lies the problem, the prices in the market are dictated by investor sentiment, if investors feel bullish, then prices are rising, if prices are rising, investors are happy and don’t see a need for protecting their investments.

On the flipside, once prices have fallen, investors head for safety, resulting in a demand for capital protected products. More importantly, capital protection can allow you to leverage and gain exposure to markets that have potential for significant returns without the capital.

Primarily, many of the capital protected products allow you to borrow up to 100% of your investment, allowing you to gain exposure to markets that have potential for significant returns without the capital. However, another major factor is simply, peace of mind. Whether we acknowledge it or not, we’re emotive in our own investment decisions. It’s difficult to feel good about investing in the market when its just fallen by 50% and everyone around you is talking about how much their investments have fallen, it’s far more pleasant to invest when the market has risen 50% and everyone around you is slapping you on the back that you’ve made the right decision and how much they’ve made. As a result, many investors to some extent find themselves investing after they’ve seen significant rises in the market and selling out when the market has fallen.

Timing the market is pretty much impossible, missing out on just a few days when the markets turn can significantly reduce your returns, so most experts live by the maxim that its time in the market, not timing the market, that’s the best approach.

A tale of two structures

Although there are numerous products out there offering protection of sorts, with the exception of Axa’s new product which uses Dynamic Hedging, the protection offered is generally a derivation of two basic structures;

1. Constant Proportion Portfolio Insurance (CPPI)

2. The Bond + Call structure

Understand these structures and you’ll understand 95% of the products currently being offered.

CPPI CPPI is a trading strategy that automatically moves investors in and out of the share market as it rises and falls. The basic concept is: If the market goes down, more money is switched into bonds and cash If the market goes up, more money is switched into equities Any shortfall at the end of the term is paid for by the CPPI manager. Bond + Call Bond + Call is packaged product made up of two parts: 1. A safe asset such as a term cash account or fixed interest bond to produce fixed amount at the end of the term. 2. An equity based asset such as a call option or futures which provides magnified returns to the investor.

Dynamic Hedging We should also mention Dynamic Hedging, a relatively new product to the retail investor in Australia. This is basically an insurance premium you pay the provider for your protection. The term Dynamic Hedging relates to how they provide the protection, but in essence, you pay an insurance premium, they provide the protection. It is the provider that is exposed to any shortfall.