01 April 2010

Dear Investor,

Capital guarantees - more than meets the eye

The headlines in recent years have chimed the arrival of a milestone in Australian demographic history. The (in)famous Baby Boomers are starting to move into retirement.

The challenges of an ageing nation

The challenges that this presents to Australia as a nation are considerable. According to the Australian Bureau of Statistics, Baby Boomers made up about 40% of the working population in 2007. Their retirement is likely to lead to significant labour shortages and strain on government budgets and social security. Further, as life expectancy increases, retirees' savings will need to last far longer. For example, as at 2010, the life expectancies of 60 year olds are 23.4 years (for males) and 26.6 years (for females). By 2050, these figures are projected to increase to 29.2 years (for males) and 31.4 years (for females).

At a governmental level, a range of initiatives has been put into place to deal with these demographic challenges. For about twenty years, the compulsory superannuation scheme has forced working Australians to put something aside for their retirement. Just last year the federal government announced that it would be gradually increasing the retirement age to 67 by 2023, in an attempt to keep a higher proportion of the population working, rather than receiving retirement benefits. Also, the annual intergenerational report has quickly become a key driver of the federal government's budgetary policy review.

However, it is not just governments who are changing policies in response to the aging population. The financial and investment industry is evolving a variety of products aimed at assisting those who are at or near retirement age. In this edition of Investment News, we take a look at the much-trumpeted 'capital protected' or 'guaranteed' investment products.

How capital guarantee works

The global financial crisis hit many retirees hard, as they saw their retirement capital diminish considerably. Although many of the losses have now been recovered, many investors were undeniably left with an increased desire for certainty. With characteristic resilience, the financial engineers saw this as an opportunity and began structuring new classes of products.

The details of these often-complex products differ from fund to fund. However, the underlying principle for them all is to provide investors some form of capital certainty or guarantee. Typically, this is achieved by the fund placing the majority of investors' money in low return/high security investments, with a much smaller amount placed in return-generating investments.

On the face of it, such an investment philosophy would have attraction for some investors. However, there is a number of risks associated with capital guaranteed products that receive little publicity. Although these products are marketed as providing peace of mind, careful consideration is required before investing in them.

Cost risk

It is a truism that there are no free lunches and the truism is doubly true for 'guaranteed' products. The product issuer is not providing a guarantee out of the goodness of its heart. Instead, investors are effectively purchasing the guarantee by paying significantly higher fees and/or tolerating a substantially reduced return. So whilst the guarantee might provide some stability to the capital amount, it does so at the cost of a considerable portion of the rate of return. Even if successfully executed, this investment approach presents its own risks. If the capital is protected, but there is no return, an investor will have actually gone backwards once inflation is taken into account.

Institutional risk

A second consideration is that a guarantee is only as strong as the institutions that are offering it. It was the backing of ostensibly 'bulletproof' institutions, such as Lehman Brothers, that seduced many investors into investing in products like minibonds in the years leading up to the global financial crisis. With the lessons of the GFC behind us, one thing that we can be sure of is that no institution can be regarded as 100% risk free.

Complexity risk

Finally, many of the capital protected products are highly structured and complex. Whilst this is not necessarily a bad thing in itself, it makes it extremely difficult for average investors to assess the attractiveness of the investment. As investment guru Warren Buffet once said "I never invest in anything that I do not understand."

Casestudy

One example of the risks presented to investors by capital guarantee products was the Macquarie ALPS 5 scheme. The rate of return was advertised as guaranteed for the first year at a very healthy 12.5%, with a potential for higher returns thereafter and a safety net of capital guarantee.

However, as is often the case with such schemes, there was a catch. The investment was linked to 80 stocks on the US sharemarket. Whenever one of the shares dropped by more than 45% of its initial value for three days or more, the interest rate reduced. Once this happened to seven stocks, the interest rate would be reduced permanently to 0%.

The seventh stock fell in late 2007. Investors are now stuck in the scheme until 2013 with no return.

Conclusion

There is never any shortage of financial wizards engineering new products to sell to investors. In assessing these products, there are a few key rules to remember:

  1. There is no such thing as a free lunch. Product features like guarantees can only be included at a significant cost to investors.
  2. No investment is without risk, no matter how it is marketed.
  3. Never invest in something that you do not understand - regardless of the authority of the person recommending it to you.

Best regards,
Chris Andrews

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Chris Andrews
Head of Funds Management

t  +61 3 8610 2811
e  candrews@latrobefinancial.com.au

Chris Andrews is the Head of Funds Management for the La Trobe Group and has responsibility for the La Trobe Australian Mortgage Fund.
Read full profile here.










La Trobe is one of Australia's leading independent specialist mortgage Financiers. Its business includes residential mortgages, commercial mortgages, and investment services operating one of Australia's largest Mortgage Funds under AFSL 222213. It employs over 115 staff and has raised over AUD$10Billion to assist over 100,000 customers since inception in 1952.

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