By GRAHAM FROST 18/08/2006
Stockmarket volatility over the summer has sparked renewed interest in investments that protect against falling markets. However, while protection sounds a good idea, it costs. Should you consider protection?
In simple terms there are four types of stockmarket fund investments that provide protection:
- Plans that protect your initial investment over a fixed term while offering some upside linked to a specific Index, e.g. FTSE 100 (‘protected plans’).
- Open-ended funds that provide a pre-determined level of capital protection (e.g. 95% or 100%) every quarter while offering upside as above (‘protected funds’).
- Funds where the manager can benefit from falling share prices as well as rising (‘long/short funds’).
- Funds which use a formula to switch from equities to cash when markets fall in a bid to protect capital (Constant Proportion Portfolio Insurance – ‘CPPI funds’).
Protected plans and funds work along similar principles: for every £1 you invest sufficient is invested in fixed rate cash to return your capital at maturity/end of quarter, with the balance used to buy stockmarket exposure. Exposure is typically achieved through buying ‘call options’ on the relevant index. The degree of upside participation depends on how much option exposure the fund can afford, which in turn depends on interest rates and option prices. High interest rates mean less cash needs to be invested to return your capital at maturity, leaving more to buy options. High option prices (usually as a result of volatile markets) mean less upside participation can be purchased.
| "Returns do not include dividends which can make a significant difference to longer term returns." |
On the surface you might think these funds are attractive provided the index participation rate is at least 100%, as your investment will rise by at least as much as the market and also benefit from protection. However, returns are based solely on the index price and do not include dividends, which can make a significant difference to longer term returns.
Assuming a protected plan offers 120% FTSE 100 participation over five years and the FTSE 100 dividend yield is 3% then, as the figures below show, the protected plan will struggle to keep pace with a low cost tracker fund (assume 0.3% T.E.R.) in rising markets and during modest falls [note: example ignores averaging, which is often applied to protected plans in the final year].
| |
FTSE 100 change over 5 years |
| |
-20% |
-10% |
0% |
+20% |
+50% |
+100% |
| Tracker |
£9,180 |
£10,353 |
£11,420 |
£13,637 |
£16,938 |
£22,441 |
| Protected 120% |
£10,000 |
£10,000 |
£10,000 |
£12,400 |
£16,000 |
£22,000 |
| Difference |
-£820 |
£353 |
£1,420 |
£1,237 |
£938 |
£441 |
Protected plans can be worthwhile if full capital protection is important to you, but you shouldn’t expect to match overall stockmarket returns in rising markets unless the participation rate is exceptionally high. Some of the better current FTSE 100 participation rates are around 120-30%, which compares favourably with three years ago when they were typically 100%. Increased volatility over the summer appears to have been offset by an increase in medium term fixed interest rates, so available participation rates have been steady over the last three months.
Funds with quarterly protection also suffer from lack of dividends and returns on 100% protected funds have historically been little better than cash (although returns are subject to capital gains tax, not income tax, so there may be a tax benefit over cash). Funds with less than 100% protection could still have significant downside if markets fall consistently from quarter to quarter, i.e. a 95% protected fund could lose almost 20% over a year, arguably making them unattractive for cautious investors.
Long/short strategies represent around 50% of the hedge fund universe and the concept is attractive, as fund managers can benefit from both rising and falling markets. They buy stocks they think will rise in value and ‘short’ stocks they think will fall and/or the market index using options. In practice results are mixed, but history suggests that long/short funds rarely deliver positive returns in all market conditions. Over the last 10 years the correlation between the CSFB Tremont Hedge Fund Long/Short Index and the FTSE 100 Index has been +56%, suggesting they both generally move in the same direction but long/short funds to a lesser extent. Even during 2000-03, a period when markets mostly fell, the correlation was still +37%.
Long/short funds are not the investment panacea that some fund managers might have you believe and should never be viewed as a ‘one-stop shop’, but they can be a valuable addition to well-diversified portfolio. New rules introduced in April 2004 allow unit trust managers to adopt long/short strategies too, making this investment style more accessible to retail investors. However, only a handful of funds (e.g. Merrill Lynch UK Absolute Alpha) have taken advantage of this to date.
CPPI funds actively manage the split between cash and equities based on a mathematical formula. The idea is that when markets rise money is moved from cash to equities and vice versa when markets fall. This provides scope for reasonable upside with some downside protection and also benefits from dividends. The Keydata UK Protected Growth fund is a good example: It aims to protect 80% of the fund’s highest ever value, investing in cash and a FTSE 100 fund. At launch in March 2004 the fund had 70% equity and 30% cash exposure, compared to 59% equity and 41% cash now. CPPI is a novel concept, although rapid market falls will mean the fund’s equity exposure falls sharply, reducing the scope to benefit from a subsequent recovery.
| "There is an argument for using long/short and/or CPPI funds in moderation..." |
If you have a sensibly balanced portfolio it’s questionable whether you need stockmarket protection. Simply holding other assets such as corporate bonds and commercial property provides a degree of natural portfolio protection because they have little correlation to stockmarkets. Nonetheless, there is an argument for using long/short and/or CPPI funds in moderation, with the aim of reducing portfolio volatility without significantly compromising returns. However, until private investor-friendly long/short unit trusts become more widely available this is not especially practical as current long/short hedge fund products tend to have high minimum investments or are traded on the stockmarket, adding an additional layer of risk. Protected plans are well worth considering if you are too cautious to dip your toes in the stockmarket otherwise. While returns may ultimately be less attractive than a conventional stockmarket fund, you stand a reasonable chance of beating cash with the bonus of a peaceful night’s sleep when markets are in turmoil.