Guaranteed uncertainty

The earliest form of guaranteed equity products appeared around the end of

the 1980s. Since then, there have been a considerable number of

developments driven both by stockmarket conditions and by investor demands.

The two main product types are designed for growth and high income.

Guaranteed growth products had their heyday in the early 1990s. At that

time, they could offera 100 per cent capital guarantee plus full

participationin a market rise and often something extra besides, such as a

guaranteed bonus or market participation of more than 100 per cent.

Alternatively, some products offered periodic “lock-ins”, whereby a market

rise would be incorporated into the guarantee.

The returns are achieved with the use of derivatives. First, the provider

calculates the cost of providing the capi-tal guarantee. Then, whatever is

left over from the purchase price, after the provider&#39s own margin, can be

used to buy an option, which provides the market participation.

In the early days, market conditions were favourableand options were

cheap, hence the ability to provide returns of up to 125 per cent ofmarket

growth.

Today, the market is very different and participation rates have reduced

considerably. M&G&#39s Protected Isa, for instance, offers only 80 per cent of

market growth overa five-year term.

This 20 per cent loss of upside is a significant price to pay for peace of

mind, since one could normally expect the market to rise over five years.

It might suit someone who needed to be sure of the capital at a set time or

who was particularly risk-averse but the lower the participation rate,the

more limited the appeal. Anything less than 80 per cent would look very

unexciting.

High-income products are thus more common at present. With low interest

rates, they are also popular with investors although products usually offer

a growth option as well. Here, the cost of providing a return of capital

plus the income payments (or specified growth) is more than the purchase

price, so the difference is funded by selling an option on the index.

Because the option may have to pay out, the capital return to the investor

is not guaranteed. The current style – seen in recent issues from NDF,

Scottish Life International and AIG Life, for example – is to have dual

conditions.

First there is a “soft barrier” of, say, 75 per cent of the index&#39s

starting level. Provided that this is never breached during the full term,

capital will be returned in full. Second, if the barrier is breached,

capital will still be returned in full as long as the index finishes at or

above its starting level.

This looks like a double layer of safety but you have to bear in mind that

if the index should fall below the 75 per cent level, it is an enormous

deficit to make up. It is also important to look at what happens if both

conditions fail.

With some products, the return falls rapidly – the so-called “precipice”.

A recent issue from Canada Life, for example, will return no capital at all

if the index falls by 50 per cent or more.

The first point to consider is the investment term. Broadly, the shorter

the term, the greater the risk of the market falling without recovering –

and the barrier level will usually be higher as well. Eurolife&#39s one-year

bond, for instance, hasa 90 per cent barrier.

Second, there is the choice of index. All that is required to return

capital is that the index should not fall, so stability with low returns –

perhaps the FTSE – is preferable to high growth potential with high

volatility – say, the Nasdaq.

Finally, there is the timing. With most products, the term actually starts

some time after the issue closes. The longer the gap, the lower the real

rate of income or growth over the whole investment period, compared with

the quoted headline rate over the term.