Why Does Capital Protection Have to be so Hard?

Tony Rumble, PhD¹
The recent APRA paper questions the value of traditional managed funds, posing critical questions for financial planners. Media and regulatory scrutiny on fees and charges compound the concerns for “traditional” financial planning. On the other hand, leading advisers in the HNW and SMSF segments have been using capital protection as a key service differentiator, providing the foundation for innovative strategies for early and mid life accumulators, and for pre- and post retirement planning for retirees. Some protected products have worked well, while many have failed to deliver. This paper stress tests each form of capital protection and assesses the risks and benefits of each. It shows how advisers can select and implement prudent protection for various client risk profiles, and why this will be key to building portfolios using a core + satellite approach; and how and why key asset classes for the next 5 years demand the inclusion of protection as part of prudent portfolio construction – which may involve high rotation of satellites around a longer term core.

Overview

To protect and grow their wealth, Australian investors must make significant changes to their traditional approaches to portfolio construction. Financial planners’ relevance is under increasing scrutiny from investors and regulators, and to survive and prosper, leading financial planners have – and must continue – to change their value proposition and service offering. Part II examines the stinging APRA critique of the traditional managed funds industry, and compares this to the demonstrable returns which have been delivered by concentrated portfolios of direct equities. Part III develops the “core and satellite” approach to portfolio construction and argues that an enriched menu of satellite investments is vital to deliver investment “alpha” and a sustainable financial planning service offering. Part III critically evaluates the role of capital protection in facilitating client access to satellite investments (as well as enabling risk management of the core portfolio). In Part IV we assess the various forms of capital protection currently available and make recommendations for the ways in which each form of protection can be used with maximum efficiency.

Why traditional managed funds under-perform

Financial planning will never be the same after the GFC. Pressure on commissions and the focus by APRA on poor returns from traditional managed funds underscores the reality that leading advisers have been working with for many years. High net wealth and aspiring clients value specialist (often SMSF) advisers that deliver superior investment returns, typically using direct equities as part of their service proposition.

Until the recent APRA paper, the most accurate performance appraisal of traditional Australian actively managed equity funds has been produced by StateStreet Global Advisors, using data provided by Mercer’s.² This research shows that the median Australian active equity fund has underperformed its benchmark in 10 of the last 15 years.

 
Figure 1:Performance Appraisal – Australian Active Equity Funds 1991 to 2005
Source: StateStreet Global Advisors

In Figure 1, the benchmark is the ASX 200 index plus 2% (which is the median cost of investing in the surveyed funds, via retail or wholesale via wrap or master trust).

The irony is that these findings are not new. Asset consultants like Intech have been making similar statements for the last decade. The newly launched S&P “SPIVA” Index shows the same persistent underperformance. Traditional dealer groups, for whom the managed fund/model portfolio/wrap platform model is the basis of their business, typically counter this critique by asserting that their manager selection processes are superior and that they avoid the median performing manager/s. That stance is untenable when it is noted that manager performance persistence is weak – the StateStreet research also shows that manager’s which perform above the median don’t consistently do so – less than 1/3 of the outperformers are back below the median within 3 years. And yet – despite the evidence – this lackluster business model persists!

APRA has weighed into the debate with its recent paper “Investment performance ranking of superannuation firms.”³ The methodology used by APRA is set out in that paper, which leads its authors to make statements like the following, which coincide in many respects with the earlier findings of StateStreet et al:

“…the average firm under-performed their net benchmark by 0.9% per year…this raises a question about the value of the active approach to risk management of investment portfolios and may support our doubt about the appropriateness of the Sharpe ratio in measuring performance…

The net under-performance of the average firm appears more pronounced in down markets. This suggests either inactive risk management where investment managers appear to forego value adding opportunities in down markets or unsuccessful risk management in down markets perhaps due to costs…

The empirical data suggests that superannuation firms may be less efficient at using the tax credits from capital gains and losses than we have assumed…For example, excessive share trading could forfeit capital gains tax concessions which are available after a 12 month holding period.”⁴

The APRA paper does a great service to the community. Unfortunately it doesn’t delve into the reasons for this observed under-performance, which are summarised as follows:

• Actively managed funds, delivered using the unit trust structure, have proliferated since the 1983 financial services de-regulation ushered in by the Campbell Committee (prior to that the dominant form of externally managed investments were provided either by LIC’s (unscaleable) or by insurance products (scaleable but highly complex);
• Non insurance products do not have the same prudential requirements as insurance products or ADI’s (both of which rely on various forms of reserving to ensure investor protection) and, to be able to offer them in scaleable, open ended format, their design needs to be aware of the potential for investor loss in the event of a “run” on the fund;
• The traditional unit trust registry does not provide fund managers with details regarding individual investor’s investment timeframes, so coupled with the open ended nature of these funds, manager’s have to cater for the prospect that in times of financial distress, the level of redemptions in the fund will rise dramatically;
• As a result, traditional open ended equity managed funds tend to invest in the most liquid equity securities available to them; in the case of Australia this is the ASX 200 index. To justify their existence and fees, most managers attempt to beat the index by being slightly under or over weight specific stocks in that index (this is recognized in the APRA paper which states that “…investment managers are hired to exploit market inefficiencies to add incremental returns through market timing or tactical asset allocation and through selecting or over-weighting better-performing securities, while trying to minimize trading costs.”);⁵
• Benchmark awareness means, in practice, that these types of funds will sell stocks when the market falls and re-purchase stocks when the market rises (in line with general market movements, adjusted as desired to allow for over- or under-weighting of specific stocks);
• This leads to the high turnover experienced by traditional managed funds, which is reported in many cases as being as high as 60% to 80% turnover per annum.

The fallacy in this approach is that it is posited on the basis of an assumed need for high levels of liquidity at the investor level. Driven by the limitations of anachronistic registry technology, traditional funds are managed to provide maximum liquidity for all investors, at all times (even when not needed).

Although not many SMSF investors or advisers articulate the technical investment rationale for SMSF’s, they do know what they hope to achieve when using the SMSF approach. Investment control is cited as the top factor driving the use of SMSF’s – and an increasingly large number of SMSF investor’s shun managed funds and use, instead, concentrated portfolios of direct equities (often, to good result).

Figure 2: SMSF use of managed funds
Source: Investment Trends, 2005.

Figure 3: SMSF Trustee’s – rationale for establishment of SMSF
Source: Investment Trends, 2005

The shortcoming in the APRA paper is that it does not consider the alternatives to traditional managed funds. Those managed funds are very effective for older retirees who need maximum liquidity but for those in the accumulation phase with suitable levels of investment sophistication, the SMSF is a powerful vehicle for the accumulation of a portfolio tailored to meet their specific life and retirement planning expectations. Since Australian equities are the best performing asset class for Australian investors,⁶ SMSF’s correctly include an allocation towards them. Since the SMSF investor can assess their own needs they can implement a direct portfolio with turnover and an investment timeframe to suit those needs. Since the literature indicates the optimal number of securities in an equity portfolio to be no more than 15 stocks,⁷ the best concentrated portfolios use this approach.

One outstanding example of this can be seen in the “Model Equity Portfolio” selected and managed by the Australian research house, Lonsec. The Lonsec “Model Equity Portfolio” has generated a total return of 299.2% since inception in 2001, through many market and business cycles, and has outperformed the ASX 100 Accumulation Index by a whopping 200.3% in that period. (www.lonsec.com.au ).

The final shortcoming in the APRA paper is that it does not go far enough in revising the criteria by which investments should be measured. It does make a valuable contribution to the critique of the traditionally used measure (ie the Sharpe ratio) and it does seek to develop a new benchmark (ie the “RAVA” approach – which does take account of fees and taxes) – but it ignores the real world reality of what investors actually DO want from their investment portfolio. An excellent assessment of this is in the paper prepared by Robert Credaro of the Macquarie Funds Management group, in which Credaro proposes that investors actually value “Six Dimensions” of portfolio construction:

• Expected return;
• Excess return potential;
• Tax efficiency;
• Fee efficiency;
• Liquidity;
• Total risk control.⁸

It is the role of the financial planner to help the client achieve and improve these goals. In the next Part the paper shows how the core + satellite approach can assist, and shows how capital protected investments are a key part of this approach.

Figure 4: The “Six Dimensions of Portfolio Construction”
Source: Macquarie Funds Management

Core, satellite, and capital protection

Carefully selected satellite investments are the best way to generate investment “alpha” and for the discerning client, advice standards combining these ingredients in a tailored solution will become the norm. Clients will increasingly come to expect their financial adviser to deliver this and hence, for HNW and SMSF clients, successful financial advisers will provide private wealth management solutions to them.

The “core + satellite” approach to investing recognizes that its often unlikely that traditional investment managers can outperform their benchmark after fees, and thus that it can be more efficient to generate market “beta” by investing in the benchmark index itself, for a cost which may be up to 10 times less than paid to the traditional fund manager. This approach relies on making a range of benchmark unaware investment decisions, into assets and markets which are capable of producing outperformance returns. Since there is still some validity in the idea that investment returns are mean reverting, the satellite investments may not be held for extended periods of time, leading to the potential for relatively high rotation of satellites.

The core + satellite approach is consistent with the Six Dimensional approach to portfolio construction advocated by Credaro – where satellites are used to increase “expected return” and “excess return potential.” In doing so, care must be taken to minimize fees, to maximize tax efficiency, and to enhance risk control. This paves the way for the use of capital protected investments.

Satellite investments need to access assets and markets which outperform. Traditionally this could have been achieved by allocating, broadly, to international equity markets. But post the GFC, the utility of this approach is questionable, especially as traditional international managed funds allocate up to 50% of their portfolio to US equities.

Commentators like Peter Schiff propose that the US is in the midst of a “secular bear market” – ie. a sustained and prolonged bear market, in which the peaks and troughs of the share market (which seem to people at the time to be suggestive of a bull market) are really no more than the ebbs and flows of a prolonged period of economic pain. Whether this view is correct can never be properly tested until after the event. But look at how clearly Schiff describes the origins of the current US malaise:

“By (2007), the nation had undergone a radical transformation in terms of its economic infrastructure and its economic behavior. A service based economy had largely supplanted one based on manufacturing that was now at a competitive disadvantage to producers in Asia and elsewhere who were less burdened by regulation, high taxes, and mandated worker benefits. America had become a nation of consumers, and manufacturers were disappearing.

Reflecting that reality the balance of trade was running huge deficits, with imports exceeding exports by $800bn annually. Federal budget deficits ranged between $300bn and $400bn yearly, caused by trillions of dollars of Government spending for the Iraq and Afghanistan wars, entitlement programs, debt service, and other expenses …”⁹

But even the most cynical commentators agree that investor “doom and gloom” about traditional market’s malaise can be overcome by allocating to selected emerging markets like China, some of the better performing Asian markets, the BRIC sector (and for US based investors), Australia. Non-traditional assets like commodities feature in their investment recommendations, too. Consider the reality of the observations of Marc Faber:
“Once in a great while, the world undergoes big changes. The great discovery voyages at the end of the fifteenth century led to a huge enlargement of the world’s economic sphere. Venice – master of the previously important Mediterranean trade routes, and the world’s richest and most powerful city – was thrown into a corner of the world…

The breakdown of the socialist/communist ideologies at the end of the twentieth century and the end of the policies of self-reliance and isolation on the Indian subcontinent were the other big changes. Suddenly, three billion ambitious and motivated people joined the world’s free market economy and capitalistic system. These new citizens of the global economy are striving mightily to raise themselves to the level of affluence they see in their Western counterparts. Simply put, the free world has been joined by more than three billion people who have a similar frame of mind as the American pioneers of the nineteenth century”.¹⁰

However valuable these recommendations may be, for many Australian investors – even at the more sophisticated, HNW and SMSF level, they may fall on deaf ears: it’s typical for non-core investments to struggle to find a home, without a well developed understanding of core and satellite investment methodology. As outlined above, the core should be used to generate low cost market beta, with satellites being used to expose the portfolio to alpha generators; with rotation between satellites as required to extract maximum return with minimal risk. And to further enable investor access to these satellite investments – in new markets and assets with which they may not be as familiar as they are with Australian and traditional international markets¹¹- capital protected investments offer some valuable benefits.

Capital protection can be a way to improve the portfolio performance when measured using traditional notions of risk and return. When traditional notions are expanded to include the “Six Dimensional” approach outlined above (where matters such as total risk control) are considered, it is apparent that capital protection if it is effective, provides at least three additional, important benefits:

• Academic literature tends to focus on optimising mean-variance – i.e. defining “risk” as standard deviation of returns, and holding the greatest expected return for a given risk or equivalently minimising risk for a given level of expected return. “More risk = more return,” generally with diminishing returns as a much greater risk is required for incremental expected performance;
• While this definition is mathematically convenient, in the “real world” investors perceive negative returns much more acutely than “volatility” per se. An investor is unlikely to care about a fund fluctuating between +10% and +70% p.a., even though the volatility is high. However, a relatively modest expansion of the range to include -5% may start to induce disproportionate concern. Better measures of “perceived risk” include “semi-variance” and other statistical measures based on “drawdowns;”
• Anecdotally, investors also tend to accept negative mark-to-market better if there is a fixed “maturity date” at which they are scheduled to receive their full investment back, as opposed to a markdown in an investment (such as an equity fund) where there is no explicit “light at the end of the tunnel.”¹²

Assessing the effectiveness of capital protection

Capital protection can be implemented in 3 main ways and each method has its own benefits and risks (which means that each method will be most suitable for the conditions that the investor/adviser are seeking to protect against).

• Buying a “put option” over the asset with the exercise price struck at the level of desired protection. “At the money” put options such as those used to deliver 100% protected lending products, tend to be expensive and current pricing including interest rates of in excess of 20% pa is deemed by many investors to be prohibitive. Products like AXA North use a variation on this style of ATM put option based protection and suffer as a result from high costs;
• Synthetically replicating the underlying asset but with zero or only partial downside risk, by combining zero coupon bonds of the desired tenor with call options over the underlying asset with matching maturity dates. In “bond + call” products, if the call option is at the money and provides 100% or greater participation in the upside of the underlying asset, provide a linear or “delta 1” payoff tracking the upside of the asset, but with no downside;
• CPPI products provide full exposure to the underlying asset with the potential for enhanced leverage in rising markets, but with the prospect that in falling markets that exposure can be reduced potentially to zero – meaning that the investor’s capital will be returned at maturity but exposure to the risky asset can be low or zero if asset prices fall dramatically.

Method One – buying put options – is expensive and a performance drag, but offers the benefits of certainty and full exposure to the underlying asset at all times. Dividends or distributions from the underlying assets can be passed through to investors (as they hold the assets directly). Figure 5 shows how risk/return is dispersed for asset plus put option positions. The cost of the put option lowers the upside potential in positively performing markets but reduces (or, where at the money puts are used, eliminates) downside risk. The investor needs to trade off the cost, and level, of risk protection when using put options.

Figure 5: dispersal of returns: combined put option and underlying equities
Put option strike is not at the money.

Method Two – synthetic replication using bond + call options – is easy to deliver and understand but may be expensive (when call option volatility and prices are high) or diseconomic (when bond rates are low, leaving little risk budget aside to buy the option based exposure). Like method one, full exposure is maintained to the underlying asset at all times. Compared to method one, dividends or distributions can not normally be paid through to investors (options don’t pass these through) but can be compensated for if total return indices are used to hedge the synthetic product. Figure 6 shows how risk/return is dispersed for bond + call option positions. In this example the bond + option provides exactly the same upside return dispersal as the underlying stock, but does not pass out dividends on that stock (thus the olive green line payoff for the bond + call position is slightly negative, ie showing the opportunity cost of bond + call vs stock). Note, if accumulation indices are used as the basis for the call option, there is no opportunity cost other than the inability to claim tax benefits eg franking credits).

Figure 6: dispersal of returns, bond + call vs stock
Bond + call product in this example does not pass through dividends from underlying shares

Method Three – CPPI – gives the benefits of physical (or synthetic) exposure to the underlying asset with the ability for leverage to increase returns above the delta 1 exposure possible in method one or two. The drawback in CPPI is that if the product de-leverages (potentially reducing the risky asset exposure to zero, ie “cashlock”) then further exposure to the underlying asset and any cashflow arising from it is reduced, potentially to zero. Figures 7 to 10 shows the risk/return dispersal for CPPI products.

Figure 7: CPPI compared to underlying asset return in a rising market, showing strong outperformance of CPPI approach as a result of internal leverage.
Source: Adviser Edge

Figure 8: CPPI compared to underlying asset return in a rising then falling market, showing strong outperformance of CPPI approach as a result of internal leverage in earlier periods despite some erosion of overall return following market falls in subsequent periods.
Source: Adviser Edge

Figure 9: CPPI compared to underlying asset return in a falling market, showing “mixed” performance of CPPI eg capital is protected at maturity but, as a result of “cashlock” the CPPI product does not participate in market recovery. Source: Adviser Edge

Figure 10: “Enhanced” CPPI compared to underlying asset return in a falling market, showing benefit of including ability for CPPI product to avoid cashlock, capital is protected at maturity but, as a result of CPPI enhancement the CPPI product does participate in market recovery.
Source: Adviser Edge

Conclusion

Capital protection can enable investors to take exposure to unfamiliar assets, especially those that are suitable for use within the investment portfolio satellites. This allows for better diversification and avoidance of the low returns generated by reliance on traditional portfolio construction methods and investments (eg traditional managed funds). Well designed capital protection delivers a range of investor benefits including certainty of outcome and full access to investment upside, with minimal or zero downside (depending on the type of protection utilized).

(c) Alpha Structured Investments P/L AFSL 290054 ("ASI"). This article is for the exclusive use of the person to whom it is provided by ASI and must not be used or relied upon by any other person. No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented, which is drawn from information that may not have been verified by ASI. The conclusions, recommendations and advice contained are reasonably held at the time of completion but are subject to change without notice and ASI assumes no obligation to update this information. Except for any liability which cannot be excluded, ASI, its directors, employees and agents disclaim all liability for any error or inaccuracy in, or omission from, the information or any loss or damage suffered, directly or indirectly by the reader or any other person as a consequence of relying upon the information. Past performance is not a reliable indicator of future performance. Any express or implied recommendation or advice presented is limited to “General Advice” and based solely on consideration of the investment and/or trading merits of the financial product(s) alone, without taking into account the investment objectives, financial situation and particular needs (“financial circumstances”) of any particular person. Before making an investment decision based on the recommendation or advice, the reader must consider whether it is personally appropriate in light of his or her financial circumstances or those of their client/s, and should seek further advice on its appropriateness. The information transmitted is intended for the person or entity to which it is addressed and may contain confidential or privileged material. Any review, retransmission, dissemination or other use of, or taking any action in reliance upon, this information by persons other than the recipient is prohibited.

© Alpha Structured Investments

© Alpha Structured Investments P/L AFSL 290054 ("ASI"). This article is for the exclusive use of the person to whom it is provided by ASI and must not be used or relied upon by any other person. No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented, which is drawn from information that may not have been verified by ASI. The conclusions, recommendations and advice contained are reasonably held at the time of completion but are subject to change without notice and ASI assumes no obligation to update this information. Except for any liability which cannot be excluded, ASI, its directors, employees and agents disclaim all liability for any error or inaccuracy in, or omission from, the information or any loss or damage suffered, directly or indirectly by the reader or any other person as a consequence of relying upon the information. Past performance is not a reliable indicator of future performance. Any express or implied recommendation or advice presented is limited to “General Advice” and based solely on consideration of the investment and/or trading merits of the financial product(s) alone, without taking into account the investment objectives, financial situation and particular needs (“financial circumstances”) of any particular person. Before making an investment decision based on the recommendation or advice, the reader must consider whether it is personally appropriate in light of his or her financial circumstances or those of their client/s, and should seek further advice on its appropriateness. The information transmitted is intended for the person or entity to which it is addressed and may contain confidential or privileged material. Any review, retransmission, dissemination or other use of, or taking any action in reliance upon, this information by persons other than the recipient is prohibited.