Market safety-nets are a trade-off
Investment guarantees good in uncertain times but cost you
Investment calls on global financial markets are currently not easy to make - global markets have had a long bull run and bear market fears are rising.
If your investment horizon is long, you can be reasonably sure that despite some short-term dips, your long-term returns will be positive, but fears over shorter terms - three to five years - may be justified, especially if you invest in an index-tracking investment and offshore markets.
The choice of index and the currency risks are difficult calls to make. It is when market cycles change that banks and investment platforms entice investors with structured products.
These investments typically offer a return better than the performance of one or more market indices as well as a guarantee on the amount you invest if the market or markets from which you will derive your returns deliver losses over three or five years.
Some products will even offer you a return linked to the best of two or more
indices - the benefit of hindsight - solving the problem of which market to back.
Structured product providers say their investments allow you to get the higher returns from equity markets but protect you against losses over shorter terms.
Liberty recently launched a structured product that offers a 10% return a year over five years as long as the returns of an investment split 50:50 between the US's leading index, the S&P500, and Europe's leading index, the Euro Stoxx 50, is positive (even just 0.1%).
Ten percent a year is a cumulative return of 61% over the five years, says Henk Appelo, an investment product actuary at Liberty.
And if the return is negative, you get your capital back, less fees.
Structured products are typically offered for a limited period only - and minimum investment amounts are typically in excess of R50,000 but possibly as high as R150,000.
How does it work?
Your money is used to buy what is known as a zero-coupon bond - a bond that doesn't pay interest but is, instead, bought at a big discount, enabling you to make a profit when it matures. For example, if you invest R100 in a structured product, the product provider could buy a zero coupon bond for R70 that will mature at R100 in five years.
Using this bond, the provider is able to guarantee your capital back regardless of what happens in the markets. The provider uses the remaining R30 to buy an equity option to provide returns above the relevant index. The "pay off" of the option is linked to the growth on an index and the option is only exercised if the index is positive and the option pays a return.
There are costs to taking this option, and the provider will also make a margin. You could save some of these costs if you invested directly in an investment tracking the relevant index, but you would risk suffering a loss if, over the investment period, the index delivered a negative return. Investors should note:
It could be for 100% of your capital if the relevant index or indices are down, or the guarantee may be conditional.
For example, Investec has a structured product on the Euro Stoxx 50 with a 70% return on your investment if the index is positive after three-and-a-half years. If it returns more than 70%, you will get the full return the index delivers.
However, should the European market fall sharply during this period, delivering a negative return over the period, the guarantee will be effective only if the index is down less than 40%. In the seemingly unlikely event of the Euro Stoxx 50 losing more than 40% over the period, you will suffer the full loss.
Lance Solms, a director at iTransact, a platform for index-tracking exchange-traded funds and structured products, says you should always look for a 100% guarantee on your capital as the aim of paying for a guarantee is to remove, not just reduce, risk.
The payoff is typically linked to growth in the price change in the index or indices - without dividends - over the full term of the structured product, and there may be a limit on the returns you can earn.
To assess whether the payoff offers value, you need to consider what you could earn with dividends, what returns you may give up and the future outlook for that market.
For example, Appelo says the dividend yield on the S&P 500 has been around 2% a year for the past few years, while the capital growth (return from the price change) has been about 9% a year. The Euro Stoxx 50 has had a dividend yield of 3.4% and the capital growth has been 5.2% a year.
Appelo says Liberty's structured product aims to deliver 10% a year as this is more than the 7% you can currently get in a cash investment such as a money market fund.
It can be hard to quantify what returns you may give up for the guarantee, says Janet Hugo, an independent financial planner from Sterling Wealth.
Some products, like the one from Investec, allow you to participate in good returns if the index does well.
Another issue is that structured products' returns may be in rands or a foreign currency - an advantage or disadvantage, depending on the rand exchange rate during the investment period. Bear in mind that the rand typically depreciates over the long term.
Some structured products are listed on the JSE and you can invest via a stockbroking account or an investment platform. These products are regulated by the JSE and daily prices are published. Some products are not listed, making it more difficult to know their price, Solms says. Some are offered as a life assurer's endowment policy as life assurers pay tax on these investments for you at 30%, giving anyone with a tax rate higher than this an advantage. Check the zero coupon bond is issued by a bank whose credit is rated highly by a rating agency, as you bear the risk in the unlikely event of the bank going under.
Solms says some products cost as much as 6% over the term, but costs should be below 4% over a five-year period.
Hugo says you must watch the costs if multiple companies are involved as each needs to take a cut.