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Why you should consider capital protection for your clients

31 October 2017Eugene Goosen, TBI
Eugene Goosen, Portfolio Manager at TBI.

Eugene Goosen, Portfolio Manager at TBI.

As originators of bespoke and other investment opportunities for advisers, we know they often battle to keep their clients from jumping ship when risk is high and performance is poor.

Currently, we are dealing with extreme risk both geopolitically and locally. Major events that could dramatically affect markets are in the air, such as a further escalation of the aggression between North Korea’s Kim Jong-un and President Trump, and the critical question of who will succeed President Zuma in December as head of the ANC.

Adding a capital protection element to a client’s portfolio can go a long way towards soothing frayed nerves, particularly if it has a well thought out growth element with a strong chance of delivering. At the same time, it creates diversification in clients’ portfolios and, as we all know, diversification is the only free hedging opportunity investors get. Diversification is critical for South African investors as in general our equity portfolios are very concentrated.

Capital protection products – also known as structured products – are a good diversification tool because they provide a solid foundation on which to invest in any risky asset, anywhere in the world. Investors need risk because they need growth; especially in South Africa where our currency is weak and inflation tends to be higher than in more developed markets.

What should you look for?

Capital protected products can be structured in any number of ways but in general they are biased towards equity based solutions in order to gain exposure to risk. The capital protection element is typically term-based ? around five years – and underwritten by a bank in the form of a listed note. This is where credit risk comes into play. Even a top, highly rated bank can issue junior or subordinate credit.

It is thus quite important to see what kind of credit instrument is backing the instrument and where possible try to understand the fundamentals of the bank or other institution that is backing it. You often see structured products that use low quality credit in order to provide attractive leverage in the product, but be careful.

As regards leverage, structured products come with different levels. If, for example, you have exposure to a specific equity index that returns 10% of performance, and the structure has leverage of 2.5 times, you will receive 25% in performance.

How do clients invest?

The minimum investments for individual clients are not as large as might be expected. It all depends on the size of the tranche the bank or other underwriting institution is offering and the number of clients a wealth manager has which he feels can benefit from this product. For example, a bank might say they are building a tranche of R50 million over a month. Each individual wealth manager then tries to accommodate their clients in the tranche. These investments are then pooled together to fill the R50 million tranche. Endowment policies issued by a Life company, shares or notes issued by a special purpose issuing vehicle, or deposits issued by a Bank can be used to pool the investments.

What about tax?

It’s important to look at the tax liabilities that can arise for the investor in these products. Some products might have an income component or some sort of coupon that SARS could see as income, so be sure to consult a tax expert when advising clients on a structured product.

If an individual invests in a structured product via an endowment policy, then obviously the life company offering the endowment will be taxed within their individual policy holders fund, which currently has a tax rate of 30% which is attractive for many high net worth investors. Should the investment qualify for capital gains tax the inclusion rate is 40% thus the net tax will be 12% (40% * 30%). The insures will deduct the tax and pay the balance of the returns to the investor.

The fee factor

Often the first question investors ask is ‘what about fees’. They expect capital protection to come at a cost – and it does, but not nearly as high as one might think.

Looking at fees on an annual basis, say the fee for the capital protection product is 1%. What do you pay in a comparable equity unit trust? As a retail investor you probably pay 1%-1.5% a year on the fund, then there is the adviser fee of, say, another 50 basis points, and possibly a performance fee. At the end of the day, in a unit trust an investor can pay around 2% to 3% without even realising it.

In a comparable structured product, the investor will end up paying anything from 75 basis points to 1.5% per annum, which will include the adviser fee, administration fee and wrapping fee. In addition, the investor may receive leveraged returns which makes this investment even more attractive, as this leverage can only enhance performance.

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