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's 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's 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's
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's 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.
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