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COVER STORY (September 2007): Over protected

Investors buy guaranteed products through fear of a market downturn. But against a recent bull market, returns from non-guaranteed equity products have been far higher. Does this mean guaranteed funds offer little value? By Angelique Ruzicka

07_09_cover_story_pic.jpgThe fear of investing in equities can be blown out of proportion and lead some investors to believe that they need more protection than is necessary. Much like film stars living in fear of some overzealous fans and surrounding themselves with menacing bodyguards, some investors feel the same way and believe they need to seek protection from downturns in the market. Many investors that are too skittish to ride out the volatility wave have increasingly turned to guaranteed products instead of staying invested in plain equity products.

But statistics from Lipper and Morningstar prove that the need for downside protection over the last five years was unnecessary and the returns provided by equities were in fact far less frightening than some would imagine. Returns produced by investing in equities far outshone any provided by guaranteed products over the same period. Morningstar tables (see page 16) show that equities returned more than guaranteed funds in Germany, Italy and France. In the UK, guaranteed funds only beat equities between 2006 and 2007, but on every other occasion over the last five years equities outperformed guaranteed funds in the UK. Meanwhile, Lipper found that guaranteed funds underperformed even when compared to European mutual funds. “Basically, European guaranteed funds underperformed all European mutual funds by 37% over five years and if you compare their performance to the Dow Jones Stoxx 600 guaranteed products do even worse and underperform by 63% over five years,” says Dr Richard Ramyar, senior analyst UK and Ireland at Lipper.   

Year-to-date figures (up to July 2007) from Lipper paint a gloomy picture for guaranteed products too. “Year-to-date figures show that guaranteed products returned on average 6.9%, while European equity funds returned 12.6% on average. The Dow Jones 600 generated 19.5%, so if someone were to have invested in an exchange-traded fund linked to that index they would have done better, and ETFs are cheaper than guaranteed products too,” says Ramyar.

The nervous investor
Many investment managers such as Axa and Crédit Agricole, the UK’s National Savings & Investments and banks such as Nationwide and Deutsche Bank in Germany, are offering guaranteed products. But critics of these products say that they are often sold at the wrong time. Usually, they are sold when the horse has bolted, meaning when the worst of the market volatility is over.

Advocates of the products acknowledge that interest was shown after markets fell. “The reason why they have increased is the 2001/2002 fall of the equity markets. We saw major new interest in guaranteed products, especially for retail investors,” says Franck Du Plessix, co-head, marketing and sales, SGAM Alternative Investments Structured Asset Management.

“A lot of these products are sold after losses have occurred,” adds Todd Ruppert, president and chief executive officer of T. Rowe Price. “If you look at the explosive growth of guaranteed products, it mainly occurred after the market crash in 2000. There was no introduction of products in 1998 or 1999 for people to invest in and they were mainly launched in 2001 and 2003. Essentially, people got burnt both ways: they bought guarantees when they were disillusioned with equities and it was the right time to get into equities, but they were hurt earlier by the markets falling.”

Industry participants explain that the reason investors are drawn to guaranteed funds is for cultural reasons combined with nervousness of investing in racy investments. “I think guaranteed funds and guaranteed funds of funds that have some kind of downside protection have a long-standing popularity in a number of European countries mainly because the investor community is inexperienced in funds or nervous and guaranteed products are easy to sell over the counter. When you have a very volatile market and you’ve got a nervous investor community they tend to fall back on that kind of product,” says Diana Mackay, managing director of Lipper Feri.

The popularity of guaranteed products is also helped by the fact that the manufacturers and promoters of these funds include some of the biggest names in the industry in Europe. According to Datamonitor, ADI, Axa and Crédit Agricole are perceived as the leading competitors for capital-protected funds in France, Deutsche Bank has the best reputation for the products in Germany, while Credit Suisse is the top player in Italy and Allianz Dresdner is the leading provider in Spain. Finally, Barclays, Goldman Sachs and HSBC have the best reputation for providing guaranteed products in the UK. 

In spite of the hype and high profile involvement of some key players in the market there are some intermediaries that are less than impressed with the product and refuse to recommend them. UK website found that 60% of independent financial advisors are dismissing guaranteed equity bonds (GEBs) and don’t plan to recommend them to clients.

Bad reputation
“We don’t get involved in these products,” says Meera Patel, senior analyst at the UK’s Hargreaves Lansdown. “When we last looked at these products a lot of them failed to deliver what they said they would on the tin in terms of performance. Many are not clear about what they invest in, so we stay away.” Even when markets turn sour, Patel feels hard pressed to recommend guaranteed products. “I’d be even more wary of guaranteed products when markets are falling for the very reason that you don’t know where they are investing. If markets are the way they are now there are more defensive products one can recommend such as gilts or cash.”

Justin Modray of UK brokers Bestinvest agrees that capital-protected products have not always produced the best returns. “GEBs developed a bad reputation around three to four years ago when a number of investors found themselves sitting on large losses as their bonds matured. This is because some plans did little to protect the downside and in some cases actually multiplied the losses incurred by the underlying stock market index.”

But he feels that manufacturers of these products are starting to learn from their mistakes. He says that GEBs, for example, have shown improvements in design. “Fortunately, GEB providers are offering far more sensible bonds these days and the majority are structured so that investors’ initial investments are fully protected. A few plans could still incur losses, but the index would typically have to fall by 50% for this to happen,” he says.

Du Plessix acknowledges that some guaranteed products did disappoint in the past but he points out that they shouldn’t all be tarred with the same brush. “There are some good and some bad products,” he says. “Some products were toxic, as some payoffs that were built into the product were not good payoffs and didn’t bring added value to the end client.”

Although there has been much improvement in structuring guaranteed products, they still have too many negative attributes for some in the market to recommend them with any conviction. “They are expensive and their fees aren’t transparent. Each guaranteed product has a different structure and hedging cost. You can buy equity products that charge 100 basis points and some guaranteed funds certainly charge more than that,” points out Rupert.

Essentially, the reason why investors lose out is that they have to forfeit dividend returns in exchange for the guarantee that these products provide. The reason for this is that managers often don’t invest in equities, but instead invest in government or company bonds. “The main pitfall with these plans is that investors do not benefit from dividends,” adds Modray. “They are worth about 3% a year on a typical UK stock market fund. Although most plans currently offer 120% or more of an index upside, the index would have to more than double over five years for the extra upside to compensate for the loss of dividends.”

Here to stay?
Industry experts also point out that guaranteed products are not really valuable in a rising market. “Protected funds often average returns over the last year, so in a rising market investors lose out on the full extent of the stock market return because returns have been averaged. If markets plummet, however, then averaging is a good thing as it limits the downside. There is no averaging in equity funds, and with dividends being paid out investors will do better,” says Modray.

A further negative to guaranteed funds is that investors are usually locked in for a certain number of years. BNP Paribas’ formula funds, for example, lock investors in for two, five or eight years. So even if markets do suddenly enjoy an upswing investors won’t be able to benefit from it entirely and the dividends that are provided.

But the jury is still out on whether guaranteed products should be scrapped. Interest in the products is certainly not waning. According to Datamonitor demand for capital- protected products is on the increase and is likely to remain strong and steady. Interest from high-net-worth individuals, who have up until now been the biggest customer group in Europe interested in the product, is expected to grow by 10% a year as well, says Datamonitor.

Institutional demand is also likely to increase by between 5-10% a year. “Interest really started on the retail side, but more and more institutional clients are now using the products as they can see the benefits and the Sharpe ratio guarantee on those products looks quite attractive to them,” says Du Plessix.

Feri figures also back up the increasing interest in these funds in Europe. Back in 2002 guaranteed fund assets amounted to just over e127m, but in May 2007 that now stands at over e205m. There are signs, however, of investors shifting away from guaranteed funds in some markets, but that is not for lack of interest. “Guaranteed funds have been very important in Spain, particularly guaranteed fund of funds, but right now they are not and that is because banks have a strategy now of building their deposit base. So for internal bank reasons deposits have become more important than funds and that is why they have stopped selling guaranteed funds,” says Mackay.

Even the most hardened of critics of guaranteed funds find it difficult to recommend ousting them entirely. “I don’t want to cast any disillusionment on guaranteed products, but they can have a place in a diversified portfolio that also allows investors to participate in the upswing while still getting some protection offered by guaranteed products,” says Ruppert of T. Rowe Price.

“It really depends on what investors want,” adds Modray. “We tend to use them for clients that are very nervous investors. In some situations they have been used inappropriately but on the whole they are used quite sensibly by advisors.”

Some industry commentators are also more impressed with the new breed of guaranteed products that are out in the market. “Compared to our competitors we don’t sell just pure formula products. Within our structured product there is an active management component that optimises the risk return profile of the product. Our products are quite sophisticated because of this active management component,” says Du Plessix. “In the last five years due to the technology that is used within the capital market divisions where there is lots of research and lots of quant analysis conducted. There has been a major increase into sophistication into guaranteed products and it has benefited the final investor.”

“The new breed of guaranteed products, which take advantage of much more sophisticated investment methods, such as utilising hedging strategies, are perfectly poised to take advantage of the coming scramble of investors looking to protect themselves from the volatile markets we are now facing,” adds Phillip Silitschanu, senior analyst at Aite Group.

07_09_cover_story_pic.jpgGuaranteed to underperform
Figures show that traditional equity and bond portfolios are a far superior investment proposition than guaranteed products. But Du Plessix is quick to defend against those who compare guaranteed products and their performance against equities, by explaining that they are, in fact, a completely

different animal and that their purpose is not to outperform equities at all. “Obviously guaranteed funds will hardly do better than equities, it’s not the same profile. Basically, guaranteed funds consist of zero coupons plus an option that is either invested in an option or replicating an allocation between a risky and non-risky asset. The objective of guaranteed products is to perform just short of interest rates plus 300-400 basis points. In the bull market it is clear that they will underperform a direct investment in the equity product. It’s just not going to have the same performance as it doesn’t have the same risk.”

© fe September 2007