Investing with an 'undo' button in challenging times

The first full week of market activity in 2016 was a reminder of how volatile global markets have become.

In just five days of trading, the Shanghai stock exchange fell by 8.5%, the S&P 500 shed 4.4% and the Rand blew out from R15.48 against the dollar to over R17 before regaining a little respectability at around R16.80.

For investors and advisers alike, these kinds of developments are very unsettling.

Local uncertainty

In South Africa, the FTSE/JSE All Share Index produced a total return of 5.13% last year; but the outlook going forward is not favourable.

Political challenges, economic stagnation, Rand weakness and higher inflation means that it is difficult to be optimistic about future returns.

This kind of uncertainty dictates that any investment has to be very carefully considered. Cash, as always, provides safety, but in an environment where inflation is moving upwards, it does not offer the prospect of real returns after tax.

Mitigate the risk

This suggests that anyone looking to put money away for three to five years and hoping to see a real return on that investment is forced to take some measure of risk. The questions for financial advisers to consider are, how much risk is appropriate and what can be done to mitigate it.

One could take out insurance in the form of put options that guarantee your client's capital. But these are relatively expensive and will reduce the upside potential.

An alternative option is structured products that provide both capital protection, and in many cases, the opportunity for some form of gearing, or accelerated gains. These products usually reference a mainstream index or indices, but alter their risk-reward profile.

Structured products allow advisers to determine their client’s target return and then review and assess the level of risk to Investor capital associated with the delivery of that return. Of particular attraction to the South African Investor over the last few years has been the ability to access offshore markets and gain Rand hedged investments that also offer a level of capital protection. Costs associated with structured products are disclosed and included in the payoff profile of the product, and in many cases are proving to be lower than those associated with traditional solutions.

Looking at history

If you looked at long term returns of the various asset classes, from a return perspective, history shows that the best is typically equity and the worst is typically cash. From a risk perspective it is usually the inverse, with cash being the least risky and equities the most. What structured products do is capture equity type returns, but reduce the risk to be closer to that of cash or bonds.

This creates two benefits: if the index falls over the investment term, the capital protection kicks in, and if the index grows, the structured product can often provide equivalent or even enhanced returns of the index. The full benefit, however, is only realised if the product is held to a specific term. Additionally, investors give away rights to dividends, and must always understand that they are taking on the credit risk of the issuer.

Hit reset

However, for many, these factors may not be as important as having the capital protection. It is effectively investing with an undo button as where markets fall the capital protection can reduce or eliminate losses completely.

Investors can select an investment product which meets their objectives, either by way of access to foreign markets, or through the shape of the payoff. In short, these investments are doing what they say “on the box”.

As always, financial advisers should only consider structured products as part of a diversified portfolio and based on the investors specific needs and circumstances.