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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.

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