Vol.33 - Capital Guaranteed Investments

Capital Guaranteed Investments
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By Chris Cleary, Banner Japan K.K | November 4, 2005 | Comment on this article

Would you like a capital guarantee on your investment? Most people would, if they could have it. Cash in the bank has one, but then you are stuck with the poor performance of cash (good as a shelter in times of trouble, but longer term the worst performing asset class of the lot). Bonds have a guarantee too, but like cash that is only nominal, and in times of inflation bonds truly are certificates of confiscation. Property tends to retain value long-term and respond well to inflation, but property prices move in cycles and a lot of places have been looking toppy for some time (Japan excepted). And stocks are the mad March hare of investments, with tremendous downside as well as upside volatility – no chance of a guarantee on a stock portfolio.

But what of market neutral funds? Good market neutral funds available at retail level have been making a compounded 12-18% a year net of fees since the early to mid ‘90s. Easily they have beaten cash. They have also beaten bonds and, through the up years and down years, stocks.

What if you could have stable success and psychological peace of mind – the combination of market neutral returns and the certainty of cash? Well, you can.

Market neutral funds aim to produce positive returns regardless of the direction of the stock markets or the bond markets. They do this by employing a variety of specialist strategies within these markets and their derivatives. These strategies may involve the magnification of small but certain profits by capitalising on price discrepancies across different markets for the same instrument; they may involve spotting abnormalities in pricing arrays and anticipating they will normalise; they may involve pitting like against like instrument and using research to find the better of two pairs, buying the good one and selling the poorer one, anticipating their pricing difference will widen – this is not the forum to get technical, but the point is there are myriad strategies that will produce low-risk returns, and also that a number of strategies are employed simultaneously, thus smoothing those returns and reducing risk further.

What is available at retail level is a package of such strategies adjusted to a level of volatility that most investors can feel comfortable with but sufficient to make a decent profit. It is a fully managed package. All the investor needs to do is decide to buy the package, or not, and later to keep it, or not.

And the guarantee? A major bank (AA- or better) will agree to underwrite the whole package, guaranteeing you at least your principal, and in some cases 120%, 140%, or even 150% of your principal at some future date, which can be between 5 and 15 years from the inception of the fund. This means you don’t have to worry about your investment tanking – that it would involve a major bank failing before your money was in jeopardy, which would most likely involve circumstances such as war / disease / asteroids surrounding which your investments would rank pretty low on the list of your concerns.

Realistically your risk is that the investment does not make more than you would have if you had kept your money in cash. As you can’t invest in hindsight, the selection of the right market neutral package is so important – some have great track records, and some are designed to earn fees for the fund houses and banks that put them together. There are sheep, and there are goats.

How does the guarantee work? The classic model is that part of your capital is put into high grade collateral, such as zero coupon bonds, which will certainly be worth your initial investment by the end of the agreed time period. The rest of your money is trading capital, which is then leveraged so that it is approximately the size of your initial investment and this you are trading at 100%. There are variants on this model of course, the most radical of which is that a bank may not buy zero coupon bonds but run the portfolio above a virtual zero-coupon line. That’s their decision as the obligation on them is senior debt.

There is another advantage to the capital guarantee apart from security. There is an extra layer of oversight on the investment of the trading capital. This means there is an extra level of risk parameters in place. The guaranteeing bank has approval over the trading package.

And one other aspect of capital guarantees to be aware of: the better ones are either rising guarantees or have profit lock-ins. The guarantee might be raised every profitable year, or you might have a guarantee of say the higher of the guarantee and 80% of the fund’s all-time high – meaning you need not fear large losses towards the end of the fund’s life.

When the average novice investor parts with a lump sum they do so with a lump in their throat. The future in unknown and there are always scary stories. Market neutral funds offer steady and attractive returns, and can be underwritten by the discipline and security of a capital guarantee from a financially strong third party.

Chris Cleary
Director
Banner Japan K.K
Integrated Investments, Tax & Estate Planning Services

These funds are available in a number of currencies. For further information please contact Banner Japan:
+81 (0)3 5724-5100; www.bannerjapan.com ; questions@bannerjapan.com

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