KEY POINTS:
The last 20 years have seen tremendous advances in the range of products available to Mum and Dad saving for their retirement.
In 1984 a diversified share portfolio was one that achieved exposure to all the different sectors of the local sharemarket. NZFP and UEB shares gave you pulp, paper and packaging exposure, NZI shares for insurance, Farmers Trading Company for retail, etc.
Times have changed. Back then it was difficult to buy overseas currencies let alone overseas stocks. Today just about anything is possible - managed funds, investments trusts and exchange traded funds let you slice and dice most of the major sharemarkets by sector, by capitalisation and according to whether stocks are value or growth.
New asset classes are invented just about every other day. One of the biggest developments recently has been the advent of guaranteed products whereby a share portfolio is protected from decline. Also known as structured products these instruments sound perfect - offering the upside of say the S&P 500 index with little or no downside, not to mention throwing out lots of fees for all involved.
Apparently they are standard fare for private bankers and wealthy individuals. But do they work and at what cost?
Definitive answers to these questions are difficult if not impossible given the level of disclosure in the average investment statement. The typical "what does it cost?" section rarely adds any insight as to what gain the promoter is in for.
So it's reasonable to fear the worst. That's because costs are invariably embedded into the price of the derivative contracts. But just because they aren't transparent doesn't make their effect any less insidious.
As most advisers don't have the time or inclination to get their heads around these products a prudent approach has been "if you don't understand it, don't recommend it" and "if it sounds too good to be true it probably is".
But at last help is at hand. In the ABN Amro bank-sponsored 2007 Global Investment Returns Yearbook, the London Business School academic trio of Professors Dimson, Marsh and Staunton (DMS) look at the issue in depth: "We provide evidence on the effectiveness with which investors can seek the upside while avoiding the downside. In particular, we explore the implications of portfolio protection for the long-term risk-return profile of investors."
The professors answer the question: how might guaranteed products have performed in the past and how would their risk compare to unprotected investment in the stockmarket?
The good news for financial planners and stockbrokers who might not enjoy the complex maths, option pricing theory and derivatives implicit in understanding structured products is, according to DMS, that they aren't a good deal because they simply cost too much.
DMS find that risk-controlled products which curtail downside exposure offer limited benefits to long-term investors. Thank god for that.
Despite the complexity of the actual products the DMS analysis is reasonably easy to understand and has significance today as protected strategies are increasingly marketed locally.
Using their database, they calculate the performance of various protection strategies involving derivatives. At the same time they look at how effective various traditional protection strategies would have been over their 107-year database.
One of the most basic of these is a stop-loss strategy whereby an investor specifies that his/her portfolio is to be sold if it reaches a predetermined level within a certain investment horizon, ie if a share portfolio falls by 10 per cent within a year it is to be sold and the funds are put on deposit.
This is not unlike the strategy a share trader might employ ostensibly to maximise returns and a bit more sophisticated than buy and hold.
In fact some internet-based share trading systems are promoted as offering this feature. But the bottom line is does it work? DMS think not.
Their analysis shows that over the 107 years from 1900 to 2006 a buy and hold strategy of the US stockmarket returned an average of 9.77 per cent a year. But if a protection strategy of, say, limiting declines to 10 per cent within each year was adopted, returns would actually have been reduced, not enhanced, to 8.83 per cent a year.
The reason returns are reduced is that the strategy quits equities after a fall and misses any recovery in the balance of the year. Not only does the stop-loss portfolio underperform buy and hold, the return falls faster than the risk so that returns per unit of risk (the benchmark of many professional investors) are less for stop-loss strategies.
Bad news for share traders!
As well as stop-loss, investors may try to reduce risk or maximise returns by profit-lock-in strategies. In a profit-lock-in strategy the share portfolio is sold and the proceeds are placed in the bank once a certain level of profit has been made. Again while the idea sounds attractive the reality is different: the professors calculate that if one had instituted a system whereby profits were locked in each year at the point of a 10 per cent gain the average return would fall from 9.77 per cent a year (for buy and hold) to 5.9 per cent a year.
At a 15 per cent lock-in the return is 8.1 per cent a year, at a 35 per cent lock-in point the return rises to 9.66 per cent, again below buy and hold.
It is worth noting that both the stop-loss and profit-lock-in strategies have been calculated without deducting costs and in reality these would be substantial.
DMS list, for example, commissions, stamp duty, bid/ask spread, the cost of organising short-term programme trades and the price pressure caused by selling into a declining market.
That's more than enough for this week. In two weeks' time we look at how structured products use the derivative market to protect portfolios from the downside - and that the trade-off is usually less upside.
Brent Sheather is a Whakatane-based investment adviser
