The Words Capital Guarantee and Capital Protection Sound Sweet

The words Capital Guarantee and Capital Protection sound sweet to any investor unsure of what the future holds. Those pondering just how these new high return structured products actually work also see comfort in these benefits. To understand how they work is to carefully read the prospectus and that is not always easy.

There are several ways capital can be preserved and it pays to understand the effect each method has on the overall risk and return. A few offer a straight out capital guarantee but not many. In some, the issuer offsets its own risk with derivatives or other hedging strategies. Put and call options are also often used to lock in profits or reduce losses during the product life.

Another option involves splitting the investors’ funds into two portions. Firstly, to buy a zero coupon bond that will return the original capital invested upon maturity. The balance, invested in potentially high return investments, sometimes leveraged or geared to extreme levels.

Some offer rising guarantees so that the profits in good years are not eroded in bad years. This is achieved by a percentage of performance being added to the bond or guarantee deposit at the end of each financial year.

In some cases up to 65% of the initial investment may go to the bond. While this provides a high degree of security only 35% of your original outlay is earning the targeted high returns. Others offer the option of an early lock in or maturity if certain targets are met.

Another method of capital protection is constant portfolio protection insurance (CPPI). This method only diverts out of the target high return investments if the value falls below a predetermined threshold point.

In theory, all investment money can be working for the term of the investment. If the asset values have fallen through all test thresholds 100% of the funds will be reallocated to a bond or term deposit until maturity. Remembering of course, derivates such as puts and call options are costly and will detract from overall returns.

While it might be nice to get your money back if the world takes a huge tumble, a flaw with the capital guarantee or protection is that the initial investment received at maturity does not have the same real value as $1.00 today. This is due to the effects of inflation and the time value of money. For instance, $1.00 received in 10 years time, discounted for the time value of money, is worth $0.5327 in today’s dollars (assuming risk-free rate of 6.5% pa as a proxy for the time value of money).
 
Most experienced investors understand there is no free lunch. Capital guarantees or protection comes with a cost in terms of higher fees or reduced overall returns. High-risk, high-return products with a capital guarantee attached are aimed at cautious investors who want better returns than cash or bonds but who also want to sleep at night.

With so many complex new products on the market, and the memory of 1987 and latterly the melt down of 2000- 2001 still fresh in many people’s minds, it is not surprising that folk are loathe to place their capital at risk.

Capital guaranteed products usually require a long time frame of 6-10 years. Even if the investment is readily tradeable or redemptions can be made via the manager, the returns are aimed towards holding to maturity. It is important to note that the capital protected products allow exposure to certain assets but in return for surrendering any income related to the underlying assets.

Capital guarantees or protection are being offered on a wide range of products and use complex structures and trading strategies using derivatives to invest in high return shares, options, corporate and emerging market debt, futures and commodities.

As always, the catch is in the detail. While your capital might be guaranteed investors should also be aware that capital protection comes into force only at maturity. If you sell before maturity you receive the market price of the day.

Original Article published February 2006