Investments that offer a “capital protection” sounds like a great way for you to protect your investments from tumbling investment markets during the global financial crisis.
They claim to give you the ability to enjoy investment returns in the good times while protecting you from losing your money if it all goes pear-shaped. Yes, we all want to avoid the pain of seeing our hard-earned investment dollars go backwards and while capital protected investments might look as simple as it sounds, they are actually more complex than regular investments.
So, before you jump the gun and start investing, you need to fully understand what “capital protected” means and how does it benefit you as an investor. After all, there is not a “one size fits all” approach to investing.
What are capital protected investments and how do these products work?
When you invest in shares or other market-linked investments, there’s a risk that the dollar value of your investment can go backwards as well as forwards.
Capital protected investments offer you the ability to earn a market-linked investment return, while having the security of knowing that you will at least get back the dollar value of your initial investment amount at the maturity date if investment markets turn sour.
For example, a capital protected investment linked to Australian shares may offer to pay investors a return equal to 80% of the cumulative growth in the S&P/ASX 200 share index over six years, with a promise that if the cumulative growth turns out to be negative you will still get back the original amount you invested at the end of the six years.
Most capital protected investments are for a fixed term, generally of six years or more, and fees usually apply if you want to exit the investment before the term is complete. The capital protection generally only applies if you hold your investment for the full term.
No two capital protected investments are the same, so you need to pay special attention to the structure, investment maturity date and terms and conditions that apply.
Another important thing you should take note is that even with ‘capital protection’, no investment is 100% secure. In certain extreme circumstances (for example, if the company providing the protection goes belly-up), you can still lose your money.
Even if you are confident about the security of the guarantee or protection, you need to weigh up the cost of these products with the benefits they can provide.
Here are the 5 things to consider before investing in capital protected investments
- Investing in a capital protected product is not the same as putting money in a bank
Capital protected investments are structured, complex investment products. Even though banks and other authorised deposit-taking institutions such as credit unions and building societies may offer capital protected investments, if you invest in one you don’t have the same security or rights that apply when you put money into a savings or transaction account.
Different capital protected investments can have very different investment and legal structures. So, make sure you read and understand the Product Disclosure Statement (PDS) or the prospectus for an investment to find out how the protection is provided.
- The benefits of protection need to be considered against their cost
Like any investment product, there are fees and costs involved in capital protected investments. You need to weigh up the cost of the protection against the benefits the product offers and consider what’s right for you. The PDS or prospectus should contain information on all the fees and costs that apply, so always read it and ask the issuer or your financial adviser for more information if you are unclear about something.
Generally, these products are more expensive than simpler investment products because of the extra cost of providing a guarantee or protection. This does not necessarily mean, however, that the returns will be higher, especially over the medium to long-term. While investment markets can go up and down over short periods of time, in most investment classes, the risk of a long-term decline is much less.
- The protection is only as good as whoever stands behind it
Before you make an investment in these products, you need to assess the risk that the issuer or the provider of the capital protection could fail to meet some or all of their obligations to you as an investor (for example, their obligation to return all your capital on the investment maturity date). In investment-language, this is called ‘assessing the counterparty risk’.
When you look at capital protected investments, make sure you find out which company is responsible for providing the protection. This information should be clearly disclosed in the PDS or prospectus. Sometimes, the investment is issued by one company, while the underlying protection is provided by another.
You need to consider the financial strength and stability of the company who provides the protection, especially when it is provided over several years. Check if there are any circumstances in which the protection could cease to apply (for example, if the issuer or the company that has provided the protection becomes insolvent).
- Inflation can eat into your capital even if falling investment markets don’t
Capital protected investments promise to at least return the money you initially invested at the end of the investment term. What these products do not do, however, is to make any adjustment to reflect changes in inflation.
Inflation means that the purchasing power of money declines over time, so a fixed amount of money (that is, your initial investment amount) is worth less in the future than it is today.
For example, if you were to invest $100,000 today for five years, you would want to get back at least $115,927.41 at the end of the five years to ensure that your money has not been diminished by inflation (assuming inflation is 3% per annum).
Most capital protected products do not include inflation in their protection and so will only promise to return you the original $100,000 at the end of the five years.
- Check if you are able to cash out your money early
If there is a chance you may need to access your money in a hurry, carefully consider the investment terms and conditions relating to early redemptions. Most capital protected investments don’t mature for six years or more, and hefty break fees can apply if you want to get out early. In addition, if you exit the investment early, the protection may not apply, and you could get back less money than you originally invested.
Are capital protected investments the right choice for you?
A capital protected investment can form a useful part of a portfolio if you fall under the following categories:
- Focused on Life’s Milestones
People who are investing for a specific long-term goal, such as future education expenses, retirement, or a vacation home, usually have a good idea of the minimum amount they will need to meet their objective. For these investors, returns over and above their goal are ‘nice to have,’ but not a necessity. On the other hand, they cannot tolerate the idea of failing to meet their goal, and thus they often favour fixed income or cash investments over more volatile equities. Because returns from fixed-income investments have historically lagged those of equities, however, these investors may have to save a much higher proportion of their income to meet their goal.
- Nervous Nellies
All investments entail a trade-off between risk and reward. Investors typically will take on more risk when they are convinced that the potential for higher returns outweighs the risk of losses. Some investors, however, have such a high degree of loss-aversion that they have difficulty taking on a rational amount of market risk.
According to the “prospect theory” of behavioural finance researchers, these investors evaluate gains and losses in an entirely different manner, attributing more importance to investment losses than investment gains. Whereas these investors are happy when they gain $100, they are not twice as happy when they gain $200. Conversely, they consider a $100 loss more important than a $100 gain. This tendency to avoid any losses relegates their portfolio to fixed-income and cash investments.
While these investors may never find equities attractive, capital protected investments allow them to participate in potential equity market gains while protecting their principal.
Those Who Cannot Let Go
On the other hand, some investors have such a high degree of confidence in their investment decisions that they have difficulty letting go of poorly performing stocks. When a stock holding declines, they tend to take increasingly risky bets to break even. Research has shown that investors tend to hold on to poorly performing stocks even when it’s clear that they should have reallocated a portion of their funds to safer investments, such as fixed income or cash. For investors who fit this profile, capital protected investments offer an effective way to avoid reckless behaviour without sacrificing the potential of recieving returns.
Investing in NEBA’s Structured Product
NEBA’s Structured Notes are designed to complement your overall investment strategy. All our notes are issued by renowned A-rated banks such as Morgan Stanley, EFG, Commerzbank and Credit Suisse.
While some capital protected investments limit the capital growth you are entitled to if the investment goes well, investing in NEBA’s Capital Protected structured note allows you to enjoy the extra upside if the investment market perform better.
Here’s an example of NEBA’s Capital Protected Structured Note:
To view the list of our current Structured Products including capital protected notes, visit http://www.nebafinancialsolutions.com/current-structured-products.
Click http://www.nebafinancialsolutions.com/Risk-Rated-Portfolio-DFM, http://www.nebafinancialsolutions.com/real-asset-fund to view our UCITS Funds.