Despite the historical success of using a combination of stocks and bonds to provide downside and upside protection, investors continue to search for new
investment vehicles that purport to offer improved methods of limiting investment losses.
In response to this demand, many in the financial services industry have been feverishly toiling in the product development department. As we head into what's likely to be a recessionary economy in 2008, your clients may request your advice on products that aim to limit losses. However, investors who don't understand the fine print may quickly discover that there is a downside to downside protection.
The period during and following the
bear market of 2000-02 was prime time for product development. Investor anxiety paved the way for the popularity of products such as principal-protected mutual funds, equity index annuities, principal-protected notes and put options/ derivatives. It wasn't until a market rebound, however, that many investors realized that they would have fared better in a traditional stock/bond portfolio. Why is that?
Anxious investors flocked to principal-protected mutual funds following the 2000-02
bear market. While these investments typically did a fine job of protecting on the downside, the upside was less than many expected. Investors usually had limited asset classes from which to choose and had to commit for a period of five to 10 years with the principal protection only at maturity. Furthermore, the fund company or, potentially, the insurance company that backed the principal determined equity exposure and could decrease it to help prevent further losses if values fell too much. This limited the upside potential.
Several of these funds had equity exposure of approximately 5% at the end of the
bear market. As a result, not only did some of these investors miss the attractive returns that followed the
bear market, they generally incurred fund operating costs that were up to 0.5% higher due to the expense of principal protection.
During the 1990s and 2000s, equity index annuities became popular, but many investors misunderstood them, leading regulators to issue "investor alerts."
While structures varied, investors typically could receive a minimum guaranteed return, lock in market gains from previous years and get one-time bonuses for investing.
But consider the calculation method for upside potential in one particular product that offered 100% of the average increase of the Standard & Poor's 500 stock index. First, the
dividend from the total return of the S&P 500 was subtracted. For example, if the total return was 10%, the return less dividends may have been 8.3%.
The pitch also referred to "average increase," defined as the simple average return for each month of the year. Funds might return 2% for a few months, 5% for a few months and then lose money. Let's assume that the index's total return at the end of the year was 8.3%. But the average (adding up the monthly returns and dividing by 12) was mathematically closer to half that, or something in the area of 4% or less. So in this example, while the total return for the S&P 500 was 10%, the investor may have received a return rate comparable to certificates of deposit or Treasury securities.
Principal-protected notes promise to return an investor's original principal and share in the upside of an equity index. Formulas vary from contract to contract, and while some are more favorable than others, complicated structures that limit upside returns in good markets are relatively common.
In one example, an investor could receive 100% of the average quarterly return of the index, with a 5% quarterly cap. Some investors assumed they would receive the first 20% of the index (5% multiplied by four quarters). In reality, the pattern of returns mattered as much, if not more, than the annual returns.
Let's assume that the return of the S&P 500 was 10% for the year — flat for three quarters and 10% in the final quarter. Our principal-protected-note investor would have earned just 1.25% for the year, or one-eighth of the annual return of the index (derived by dividing the quarterly cap of 5% by four quarters).
When structured properly, a principal-protected note can be a good solution for an investor; however, these complicated solutions tend to be more profitable for the issuing firm and hence more prevalent.
While the previous products are designed to offer full principal protection, put options/derivatives typically do not. Portfolios of funds, ETFs, separate accounts or similar investments may allocate a portion to put options or other related investments to help limit the downside.
Some investments offer the opportunity to use put options in lieu of bonds for a portion of the portfolio. While it may make sense for some investors, in general, puts are more expensive than bonds, costing approximately 2% to 5% per year in continuing programs, which could create a significant drag on performance in a single-digit-return environment.
Furthermore, the long-term performance of this type of strategy should be questioned. Historically, an index such as the S&P 500 has risen over time. If this trend continues, as it has for many decades, money used for put/derivatives-related strategies may be lost.
According to the prospectus of one provider using a put/derivatives-type strategy, the returns in that fund have indicated a total return of -100% (complete loss of capital) after taxes for roughly the last decade.
While the search continues to find a better solution, larger institutions may have already found one. These institutions complement their stock and bond portfolios with alternative asset classes, such as commodities, hedge-fund-like strategies and currencies.
Alternatives tend to behave differently from traditional stocks/ bonds, which can serve to help mitigate downside risk yet maintain upside potential.
No one expects financial professionals to stop developing new products, and we don't expect your clients to stop asking for them. While financial institutions have been successful at raising billions of dollars (which is the goal for product originators), longer-term evidence that these products have been better for investors is either weak or nonexistent.
Many of the programs created have higher fees, complicated structures and features that sometimes limit upside potential and more. Given the complexity of many of the programs in the marketplace, it's more important than ever to read the disclosures, prospectuses and fine print. As the old expression goes, if it sounds too good to be true, it probably is.
Charles W. Widger is chairman and CEO of Berwyn, Pa.-based Brinker Capital Inc., an independent investment management firm that provides managed-account investment programs to individual and institutional investors through financial advisers.
