Capital protected products are engineered to offer peace of mind to investors who typically want to benefit from the potential rise of the equity market without having to risk their initial investment. Investors are guaranteed to have back their capital, or at least part of it, generally at maturity, plus a return, which is usually linked to the growth of the underlying investment.
“The demand for capital guarantee is a function of the panic in the market, the higher the panic, the higher the demand,” says Ferdinand Haas, head of product solutions Europe at DWS Investments. “The big problem is that investors demand guaranteed products exactly at the wrong time, when markets have gone down rapidly, they are very cheap and risk premia are very high.”
Every guaranteed product can be split into two components, the ‘underlying’ itself, typically an index or basket of indices, and the ‘put’ option on the underlying, which becomes more expensive as volatility goes up. “When volatility is high, the cost of insuring a portfolio is more expensive, which drives expected returns down. Smart investors should demand capital guaranteed products in times of market euphoria, when the price of ensuring your capital is rather low and the risk of markets dropping is quite high,” says Mr Haas. “Building these products as efficiently as possible, given the current environment, is our key challenge.”
Over the past 18 months the German asset management firm has built products that have constant exposure to volatility, which automatically de-leverage in highly volatile markets. “We have created a series of actively managed indices on various investment themes, where portfolio managers pick and build their portfolios and can change the index composition on a daily basis. We have then introduced a volatility adjusting mechanism which is completely automated,” he says.
The so called vol-targets indices will always have a constant volatility, as the product built on them will have higher or lower exposure to the market, depending on whether the market is respectively less or more volatile. “By doing that we don’t buy volatility when it is very expensive, and on the other hand, we are not invested in markets when they are highly volatile, and this has really helped our products in terms of performance,” says Mr Haas.
This volatility adjusting mechanism is applied to both option based products, or formula funds, which are closed-ended funds whose payout is defined by a predefined formula, and CPPI (constant proportion portfolio insurance) strategies, where portfolio managers make the necessary adjustments applying dynamic trading strategies.
Because of their nature, principle protected products can incur big after sales issues, explains Nicolas Gaussel, head of quantitative management at Lyxor Asset Management. “When markets do well, the principal protected product participates to only a percentage of the market rise and clients might be frustrated if they did not anticipate this effect. When markets decrease rapidly, and are very volatile, the product will have to reduce its exposure to markets until having no exposure at all, in order to protect the capital. If the markets go up again, the manager will not be able to invest again, the product is monetarised, ie no longer exposed to equity markets. This is a very nasty effect which sometimes creates a lot of frustration in clients,” he says.
missing out
Many principal protected funds launched in 2000 that had five or eight year maturities were monetarised because of the tech bubble bursting, and the same happened during the recent financial crisis to similar funds that were launched in 2004 and 2005. “These products have done their job as they have protected investors’ capital, but investors now feel they are stuck with this investment, because they are not participating in the current market rise,” adds Mr Gaussel.
For formula funds, but also for CPPI products, it is critical that both the prospectus and distribution network sales force make clear that the investor runs the risk of not being invested in the market, he explains. “At Lyxor we prefer to offer solutions that avoid this monetarisation effect. For example, we believe that open ended products with a yearly guarantee ensuring that investors wil not lose more than 90 per cent of their initial capital, have the key advantage of protecting the principal and year after year, investors are sure to be exposed to the equity market”
In the affluent or high net worth segments structured notes with capital protection are generally more popular than capital protected funds, as they can be tailored to individuals’ needs, and, having a quicker time to market, they can react to market themes more rapidly. But capital protected funds have traditionally appealed to the retail segment because of its diversification and daily liquidity. The majority of the E20bn total assets that the French firm manages in principal protected funds are sold to retail investors either through banking networks or insurance unit linked contracts.
