View more on these topics

Rough with the smooth

Arguments abound that with-profits have had their day and that we need to search for new alternatives. The sins of the father have cast us to search among his progeny for a new alternative “default” investment strategy.

Necessity being the mother of invention, portfolio insurance (or constant protection portfolio insurance)is being hyped by many marketing departments as the heir apparent to the mantle of with-profits funds.

However, beyond the sound and fury of the marketing output, I am not so sure. This particular offspring seems to have inherited father&#39s flair for spin and several of his most serious defects.

Before I go any further, I think it only fair to declare my hand. I have taken a consistent line against the marketing of with-profits funds for several years now – not because I think with-profits are a bad investment concept (far from it) but because of the way in which it was presented to investors – all the upside of the stockmarket with guarantees. All well and good in a rising market but in a falling or volatile market, things do not go as smoothly. This volatility risk of with-profits was rarely presented to investors.

As the stockmarket fell, life offices would be forced to sell equities and buy bonds to ensure they could meet their guarantees. With the fund “cash-locked”, it was effectively game over for these investors no matter what the stockmarket did.

Fortunately, with-profits does have one saving grace against this volatility risk – smoothing. During 1998, the stockmarket took a huge short-term hit, if unsmoothed, many with-profits funds would have been forced to sell equities immediately.

Consequently, they would have benefited very little – if any – from the subsequent rebound. Fortunately, life offices were able to remain invested in equities by plugging the gap in their funds from reserves. When the market rebounded, so too did the value of with-profits funds and the smoothing reserve was recovered.

However, there is a finite limit to how far the office can smooth the market, just ask Standard Life. That being said, the ability to withstand short-term volatility risk is a feature of with-profits that has allowed the concept to survive for so long. There remains an important place for with-profits funds in the future, especially for offices who have the financial strength (as measured by the new realistic balance sheet) to run the concept successfully.

And so to the heir apparent. CPPI is similarly presented as stockmarket perf ormance with guarantees but is also fully transparent. There is no doubt that is the case, however, just because investors can see how the fund operates it does not mean they understand it. Yet again, the great and the good of our industry have confused quantity of information with understanding information.

CPPI is, in fact, a withprofits fund without smoothing. All these funds have a specific formula which forces the fund to sell equities as the market falls and buy it back as the fund rises.

However, there is a small twist in the previous statement, many would read it as selling equities as the stockmarket falls and buying equities as it rises, but that is not at all what it says.

What the statement actually means is that as the stockmarket falls you sell equities, however, you will only buy equities again when your fund, which is now largely composed of cash, rises once more – and at these interest rates how long will that be?

CPPI funds can become “cash-locked” very quickly -a short downturn in the market can be game over for these funds. This is why so many people have lost faith in with-profits and yet this “alternative” has the fault in extremis. Reading the marketing literature for some of these products you could be forgiven for missing this volatility risk, if the warning exists at all.

Short downturns followed by quick rebounds are a feature of the stockmarket. Look at the market following September 11, look at Y2K and LTCM. How many investors in CPPI understand how much their fund deleveraged from the stockmarket during the Madrid bombings, for example? This son of with-profits is not equipped to cope with the modern volatile stockmarkets, it only works in a smooth market, but what&#39s the point in a protected fund that only works when the market is not volatile? So why is it getting such a heavy push in the market?

The answer seems to be money. Investors in many forms of CPPI have a wonderfully sounding concept known as “crash insurance” this stops the fund falling short, say by 20 per cent. This crash insurance is typically charged at about 0.5 per cent a year (on the entire portfolio, the cash included).

However, the probability of the stockmarket falling by 20 per cent in any one day is low but not impossible, just highly unlikely, but the actual cost is well below 0.5 per cent.

Few product providers, let alone advisers or investor, are capable of valuing the benefit efficiently and so the investment banks providing this insurance can make a financial killing on ignorance.

The CPPI concept is thus bankrolled by these easy profits. Unfortunately, over the long term, these costs, coupled with volatility risk, will mean many investors will end up extremely disappointed in their ultimate returns.

If our search is to find a true alternative to with-profits then it must not be based on hype and easy profits. It must be based on an understanding of what investors really want from this type of investment. Those who fail to learn the lessons are doomed to repeat the failings. Let us learn from the problems of with-profits rather than exaggerate them.


New Star hits back at FSA claim

New Star is reportedly threatening to sue the FSA for defamation after a newspaper quoted an FSA press spokesman saying the 21 firms embroiled in the split-cap debacle had “ripped off consumers”. New Star is understood to have exchanged letters with FSA, which argues that it has not named any of the firms or passed […]

Prestbury issues profit warning

Non-regulated network Prestbury Holdings has issued its second profit warning of the year and has raised £500,000 through a placing of £1m of new convertible loan stock. The company says the marketing joint ventures trialed by its Moneybrain division have failed to deliver the results that had been expected. Prestbury chairman Francis Maude says: “Prestbury&#39s […]

Excise steps up VAT review

HM Customs and Excise has contacted several more IFA networks to discuss their situation as part of its review of the way IFAs pay VAT. As revealed in Money Marketing last week, networks are not being singled out for special treatment. Instead they are being contacted individually as part of a national review of IFA […]

Inside edge – Andy Young

It is hard to think of an industry that has gone through the same turmoil as financial services and each week there seems to be another issue about to turn the industry upside down. Mortgages are certainly one of the hot topics right now as everyone jockeys for position ahead of regulation in October. What […]

How QE is distorting the gilt market

By Mike Riddell The moves in gilts in August were truly exceptional. Volatility in the gilt market (based off 10-year gilt futures) has soared to close to the highest levels seen this millennium, on a par with the eurozone debt crisis of 2011/12 and behind only the global financial crisis of 2008/09. The first distortion […]


News and expert analysis straight to your inbox

Sign up


    Leave a comment


    Why register with Money Marketing ?

    Providing trusted insight for professional advisers.  Since 1985 Money Marketing has helped promote and analyse the financial adviser community in the UK and continues to be the trusted industry brand for independent insight and advice.

    News & analysis delivered directly to your inbox
    Register today to receive our range of news alerts including daily and weekly briefings

    Money Marketing Events
    Be the first to hear about our industry leading conferences, awards, roundtables and more.

    Research and insight
    Take part in and see the results of Money Marketing's flagship investigations into industry trends.

    Have your say
    Only registered users can post comments. As the voice of the adviser community, our content generates robust debate. Sign up today and make your voice heard.

    Register now

    Having problems?

    Contact us on +44 (0)20 7292 3712

    Lines are open Monday to Friday 9:00am -5.00pm