Personal finance: Playing it safe

By MARK FRYER

For any investor it's the eternal question - play it safe and accept a low return, or take a punt on something that may be more rewarding, knowing you could lose your shirt?

After all, as every textbook says, you can't have return without risk.

However, there are investments that promise to turn the risk/return relationship on its head by offering safety and the chance of a high return.

They're known as "capital-protected" investments, or "capital-guaranteed", or "structured" investments.

The last name gives an idea of how they work - typically, by combining two investments into one structure. For example, an investment in bonds (that's the safe bit) combined with an investment in the futures markets (the bit that might provide the return).

They're popular in many parts of the world, for obvious reasons; after years of falling sharemarkets, many investors can't bear losing any more, but don't want to miss out when markets rebound.

In New Zealand, variations on the theme have been offered by several managers since the late 1990s.

Are they too good to be true? Not necessarily. It is possible to have a bit of both - but don't expect to get it for nothing.

These investments typically come with extra costs, which may not be obvious. There's also a cost in the loss of flexibility they involve. You need to be ready to lock up your money for a set term in order to enjoy the promised protection.

But if you're prepared to do that, and happy to pay, such investments can offer comfort to nervous investors.

Not that they remove risk entirely. Among other things, investors need to be satisfied with the financial strength of the institution making the promises.

You also need to be aware that you're not always investing directly in the markets concerned. Rather than buying shares, for example, you may be buying "derivatives" which reflect the return on shares, a difference which adds new risks.

If you don't fancy giving your money to a fund manager, you can always set up your own capital-protected investment, using that good old-fashioned strategy called diversification.

If you've got $100,000 to invest for five years, for example, put $85,000 in the bank. Even at 5.5 per cent interest, even after tax, five years from now you'll have at least your initial $100,000 back.

Put the remaining $15,000 into whatever takes your fancy. If you win on the markets you're ahead. If not, you've still got your original stake.

If you prefer the managed approach, two investments on the market right now take different approaches to offering investors the best of both worlds.

But there are also some similarities: neither will be listed on any sharemarket and both are "closed-ended" funds, meaning they raise a set amount then close to new investors. One will pay no dividends and the other next-to-none.

And both make it clear that they are for investors who are prepared to lock their money away for a long time.

Liontamer MSCI World

Index Trust

The promoters call this a "capital-protected" investment rather than using the word "guarantee". As the investment statement makes clear, no one is going so far as to guarantee you a return, or your original money back, though that's the goal.

* The promise: Your money back after seven years, plus 1 per cent a year, plus any increase in world share prices over that time, if they rise by more than 7 per cent.

* How it works: Investors buy units in a unit trust (minimum investment $5000, closing date June 27). The managers then use that money to buy something called "equity-linked notes" which are issued by giant US financial services group Morgan Stanley.

The value of those notes reflects the value of international shares, as measured by the MSCI World Share Index, which is a widely used measure of the price of shares on the developed world's major markets.

If share prices double in the next seven years, investors get back $10,000 for their minimum $5000 investment. If share prices go nowhere, or fall, the return will be $5350 ($5000 plus 7 per cent). Any capital gain will be paid out when the investment matures.

* Limitations: The promised return applies only if you keep your money in for the full seven years. Pull out early and you get whatever the units are worth at the time.

Early withdrawals can be made only once every three months and will incur a fee of 2 or 3 per cent, depending on when the money is withdrawn.

* Costs: The only fee, as such, is a 3 per cent entry charge, although some financial advisers may be prepared to reduce that.

But investors are not getting something (the guarantee) for nothing. While units in the fund will share in any rise in international share prices, what investors don't get are any dividends on those shares.

As the investment statement says: "Effectively, by giving up the income from dividends, investors are able to pay for the insurance premium."

How high a price is that? Impossible to say, without a crystal ball, but the shares in the MSCI Index now pay dividends worth about 2.5 per cent a year. Given that dividends can be expected to rise, over seven years that's a return of 20 per cent or more (before tax) that investors are passing up.

* Things worth asking: Is it worth giving away those dividends, and accepting limitations on withdrawals, in order to avoid a drop in share prices? Only time will tell, but it's worth remembering that, even with all the turmoil that sharemarkets have gone through lately, the MSCI World Index is still higher than it was seven years ago.

On-line broker Moneyonline, which is selling the Liontamer fund, says that since the MSCI World Index began in 1969, there have been only three seven-year periods in which the value of the index has fallen.

* The risks: The obvious risk is that share prices may not go up in the next seven years. If that happens you'll feel more cheerful than people who invested without a guarantee, but inflation means you'll have lost money. At a 2 per cent inflation rate, $100 in seven years buys only what $87 buys today.

There's also the risk that Morgan Stanley won't be able to pay up in seven years, although investors can take comfort from the fact that it has a strong credit rating.

And, if you get out early, you run the risk that your units may be worth less than $1. Compounding that risk is the fact that more than a month can elapse between requesting an early payout and getting your money, in which time share prices can change a lot.

* Tax: The annual 1 per cent returns will be taxable as income, although investors are presumably more interested in the possible gains on the sharemarket.

Any gains after seven years will be paid as bonus units which, unless the rules change, can be treated as non-taxable capital gain by most investors.

OM-IP Plus 40 Ltd

This offering does come with an explicit guarantee, from Westpac.

It's the latest in a line of similar investments that have attracted millions of dollars from New Zealanders for the Australian-based managers, OM Strategic Investments.

* The promise: At least $1.40 for every dollar you put in, if you wait until the maturity date - November 30, 2015 - possibly more.

* How it works: Investors buy shares in the company, OM-IP Plus 40 Ltd, (minimum investment $5000, closing date July 11). The managers then deposit most of the money - probably about 70 per cent - with Westpac.

The idea is that the money that goes to Westpac will grow over 12 years, to make good on the promise to repay investors their money, plus 40 per cent.

The rest of the money is then passed on to the investment manager, Man Investments, which will try to make a profit by investing in things such as futures, options and foreign exchange.

That part of the investment is what is often called a "hedge fund" or "absolute return fund", which tries to make money regardless of the overall direction of the markets.

The managers will also borrow money to invest, in a bid to increase profits.

The managers say they aim to earn 15 per cent a year - though they're not guaranteeing that bit of the offer. If they achieve that goal it would be a spectacular feat by any standards.

If the managers do well, they can give more money to Westpac to increase the guarantee, which would effectively lock in half of any profits made in any year (after making good past losses).

* Limitations: The guarantee applies only if you hold your shares to the maturity date. Sell earlier and you'll get what the shares are worth, which may be more or less than they cost.

Investors can sell shares only once a month, and until June 2006 there's a 2 per cent early withdrawal fee.

* Costs: Hard to quantify, but - like all hedge funds - they're much higher than with a typical unit trust. There's an initial fee of 4 per cent, and ongoing fees could easily exceed 5 per cent a year. There are also other expenses, such as interest on any borrowed money, and - like most hedge funds - 20 per cent of any profits goes to the investment managers as a success fee.

* Things worth asking: What are the prospects of the investment managers making enough to cover costs make a profit?

Again, only a crystal ball has the answer. However, the Man Group has been a very successful hedge fund manager - it's often described as Britain's largest - and some of the previous funds in the OM series have performed strongly since they began operations in Australia in the 1990s.

* The risks: The big risk is that the investment managers run out of skill, or luck. As the prospectus notes, this type of investment is very speculative, especially because it involves borrowed money.

If the investment returns aren't good, investors will still get back their $1.40 for each dollar invested, which should keep them ahead of inflation, though it's less than they would earn on a bank deposit, at today's rates.

* Tax: Any profits the investment managers make will be paid out as a dividend at the maturity date, which will be taxable. However investors who withdraw early will, in most cases, be able to treat any profit as a tax-free capital gain.

Investors contemplating putting more than $50,000 into the fund should get advice on the implications of getting ensnared by the Foreign Investment Fund tax rules.

* To contact Personal Finance Editor Mark Fryer, write to: Weekend Herald, PO Box 32, Auckland. Email Mark Fryer Ph: (09) 373-6400, ext 8833. Fax: (09) 373-6423.