Money: Getting a handle on risk

By MARK FRYER

If the investment commandments were engraved on tablets of stone, second place - right after "thou shalt diversify" - would go to the old one about risk and return.

To get higher returns, it says, you have to accept more risk.

Putting things the other way round, if the thought of losing money terrifies you, stick to the safety of fixed interest - and don't complain when more adventurous investors earn higher returns.

However, two new managed investments are apparently offering to suspend that relationship, putting money into potentially high-risk areas but guaranteeing that investors will not lose.

"Capital-guaranteed" managed investments are nothing new. They generally stick to low-risk areas such as corporate bonds, Government stock and mortgages.

The new arrivals - the BNZ's EuroStock fund and the Series 6 OM-IP 220 fund - are more adventurous.

The BNZ fund will follow the fortunes of European sharemarkets, while OM-IP 220 is a "hedge fund," investing in things such as futures and options.

The two (reviewed in more detail at right) are very different, but they have a few things in common - they are a convenient way to invest in a potentially volatile area, combined with the security of a guarantee.

While this involves some complex financial engineering, there is no magic to it. And no, it doesn't violate the old risk and reward connection.

What the fund managers do is take most of the money they raise and put it aside in fixed-interest deposits. They then invest the rest, knowing that whatever happens those fixed-interest deposits will be there to make good on the guarantee.

For investors, there are no free lunches. Both funds involve giving up some of the potential returns to pay for the guarantee - less risk, but less reward too.

In the case of the BNZ fund, you get only 60 per cent of the growth in the share indexes the fund tracks.

With the OM-IP 220 fund, the managers could pay a higher return - assuming they make a profit - if they weren't also providing a guarantee.

And while they are a convenient way to invest, both funds suffer from the fact that the returns are taxable.

On the other hand, small investors have few opportunities to put their money into hedge funds such as OM-IP 220.

One more thing: do-it-yourself investors can provide their own guarantees.

How? By diversifying.

Put some of your money into term deposits or Government stock and the rest into the investment of your choice. The fixed-interest part will grow and buffer any fall in the rest of your investments.

It won't be so convenient and the guarantee will not be so absolute, but it could also be a cheaper and more flexible strategy.

Offer one: shares without the tears


What it is: EuroStock, from the BNZ.
Minimum investment: $10,000.
Offer closes: May 11.
Maturity date: May 15, 2004.
Guarantee: Your initial investment back, plus 6 per cent (6 per cent in total, not per annum).
Returns based on: European sharemarkets (including the UK).
Early withdrawal: No.

From an investor's point of view, the BNZ's offering works in much the same way as an everyday bank deposit -you put your money in and three years later you get it back, plus interest.

The difference is that the interest rate is not fixed. The BNZ guarantees it will be at least 6 per cent (in total, not per annum) but it could be more.

The amount investors get depends on what happens to two sharemarket indexes, one of which tracks 100 UK shares, the other of which follows 50 shares in the rest of Europe.

Investors get 60 per cent of any growth in those indexes between this May 15 and May 15, 2004. If both indexes rise by 50 per cent, for example, investors will get a 30 per cent return.

If the markets do not rise, or if they fall, the return will be 6 per cent.

That return is paid at maturity - there are no interest payments along the way - and you can't get your money out early. The return will be taxable, at each investor's personal rate.

The size of the return depends entirely on what happens to the sharemarkets in question; the bank does not actively pick shares nor does it try to choose the best time to get into or out of the markets.

Returns are protected against any changes in the value of the New Zealand dollar.

While the idea is relatively new in New Zealand, "virtually every high street bank in the UK or anywhere in Europe has these products," says Laetitia Peterson, head of advisory services with the BNZ's capital and risk management unit.

Though it looks like a term deposit to an investor, it works very differently from the bank's perspective.

It takes investors' money and puts the majority of it into bonds, to make sure there will be enough to make the guaranteed payout in three years' time.

The rest is used to buy derivatives - essentially, financial instruments which enable the bank to profit from a rise in the sharemarket indexes involved.

Last year the bank launched a similar investment, linked to the S&P 500 index, which tracks US shares.

That raised about $35 million from investors, who are doubtless now feeling rather smug about the fact that their capital is protected, given that the index has plunged by almost 20 per cent since the investment was launched last November.

Offer two: futures, with a promise


What it is: Series 6 OM-IP 220 fund.
Minimum investment: $A5000 (about $6233).
Offer closes: May 11.
Maturity date: December 31, 2010.
Guarantee: Your investment back, if you hold until maturity.
Returns based on: Trading futures, options, currencies, commodities, fixed-interest, etc.
Early withdrawal: Yes, manager will buy back shares.

While it also offers a guarantee, that's one of the few similarities between the OM-IP 220 fund and the BNZ offering.

Buy into this and you are buying shares in a company, although there is no plan to list them on the sharemarket.

As the "Series 6" in the name suggests, this is not the first version of this fund; the managers say the five earlier funds attracted about $A254 million from investors on both sides of the Tasman.

This time they are seeking $A80 million here and in Australia. About 60 per cent of that will be handed over to Westpac, which will invest it in fixed-interest securities to ensure there will be enough to repay investors in full at maturity date.

The rest will be put in the hands of various managers who will attempt to make a profit trading shares, options, futures, commodities and just about everything else you can buy or sell on the financial markets.

This sort of investing depends entirely on the managers' skill - or luck. As the fund's investment statement notes, it "may be regarded as highly speculative."

For an investor, the danger is limited - you are guaranteed to get your money back. But if the managers' strategies don't pay off you won't get anything more.

If the fund makes a profit in any year, after making good any earlier losses, half that profit can be given to Westpac to add to its fixed-interest holdings. This has the effect of "locking in" profits, regardless of what happens later.

While the guarantee will be a comfort to investors, getting your money back after nine and half years is not a great deal; if you make the minimum investment of $6170 (at current exchange rates), inflation at 2.5 per cent a year will reduce its buying power to about $4800 by then.

The fund's promoters argue that its big appeal is diversification, because returns are not dependent on the direction of any particular market.

As always, past returns may not say anything about the future, but the managers say the same strategy returned 21.4 per cent a year, after fees, over the past 10 years.

Investors can sell their shares back to the manager before the maturity date. But if they do, they lose the benefit of the guarantee and may suffer a loss if the fund has not been performing well. They may also have to wait up to a month to get their money out.

The fund will not pay any income and any growth beyond the initial price of $A1 a share will be paid as a taxable dividend at maturity.

Those investing more than $50,000 may also find themselves caught by the Foreign Investments Funds regime, which could mean a tax bill before the final payout.

Australian-based van Eyk Research, which reviewed the fund for its promoters, describes it as "suitable mainly for sophisticated investors who are willing to adopt a medium to longer-term investment horizon ... " It also recommends investors devote a maximum of 5 per cent of their portfolios to this fund. Given the $A5000 minimum, that implies you would need investments of around $120,000 for such a fund to be appropriate.

* Contact Personal Finance Editor Mark Fryer at: Business Herald, PO Box 32, Auckland. Phone: (09) 373-6400 ext 8833. Fax: (09) 373-6423. e-mail: mark_fryer@nzherald.co.nz.