ASIC lifts lid on capital protection

The Australian Securities and Investments Commission released its report on the Australian structured product market this week – with some damning criticism of major products provided by some large investment banks.

The ASIC report is a “must read” for any investor using, or considering, any product with “capital protection” – for under the bonnet of many of these products, real dangers can lurk. (Click here to read the report).

In a fair and balanced report, ASIC also recognised the benefits that some forms of popular structured products can provide – and in doing so, provided a useful guide for retail investors looking for an alternative to the often disappointing returns from traditional managed funds. Eureka Report readers will be pleased to learn that much of the ASIC criticism is directly in line with reports we have been running for the last couple of years.

ASIC’s key findings

The ASIC report picks up on the vague but worrying statements made by current and previous ASIC commissioners, who have commented that “some forms of complex products may be unsuitable for all retail investors.” Post GFC (and the collateralised debt obligations (CDO) debacle that triggered it), this is an obvious comment to make. But until now, we’ve all been left wondering exactly what these products are!

ASIC surveyed retail investors to gauge what types of products they are using, and to determine their level of understanding about these products. Unsurprisingly, ASIC found that many investors are attracted to products with some form of capital protection – implicitly validating comments made by former Treasury secretary Ken Henry last year regarding the problem of “sequencing risk.” (The risk that a market crash will hurt retirees far worse than younger investors).

ASIC surveyed a range of “capital protected” products including:

• “bond and call” style products – where the product is hedged by its issuer depositing a large portion of the investment into bonds (which earn interest and grow in time to be worth the same as the initial investment amount) and using the balance to buy call options, which give exposure to upside growth potential in the underlying asset. Most banks issue these style of products, which were first popularised by the MAN group (which issued under the name “OM-IP” in the 1990s), CBA, Deutsche, and Citi;
• “CPPI” products – where the full investment amount is deployed into the underlying asset from the outset of the product, often boosted with additional leverage, and where the product provider will sell down the underlying asset in the event of a falling market to ensure the investor’s capital is available at the maturity of the product. The most popular of these were issued by Macquarie (under the brand name “Fusion”) and UBS in the years prior to the GFC;
• “protected loans” – where the investor borrows up to 100% of the cost of a parcel of shares, and pays a premium interest rate to cover the cost of buying an additional put option to protect the capital value of the shares (and hence to hedge the value of the share parcel). Macquarie’s “Geared Equity Investment” and CBA’s “Protected Equity Loan” are leading examples;
• “internally leveraged” products, which use call options to deliver exposure to the underlying asset, and where the “loan” itself is “notional” or “synthetic”. Macquarie’s “FLEXI 100” and UBS are popular issuers of these products;
• “reverse convertible” products, where the investors’ cash is placed on deposit and the interest earned is supplemented by selling “barrier” put options (with the fee from selling these put options often adding several per cent per annum to the base interest return). UBS and Citi are popular issuers of these products.

I have reviewed products in each of these categories over the last few years in Eureka Report, and pleasingly, the ASIC report is in line with my analysis.

The key ASIC finding across all of these product types is that there are real limitations to the extent of capital protection that is actually available. For example:

• the interest cost on loans used to buy any of these investments is always fully at risk – and since this is often the only real outlay the investor makes, their real investment is actually not protected at all;
• where the loan is taken out for the term of the product – often many years – the investor will be locked into paying that interest until the product matures and the capital is available to repay the loan.

ASIC also noted that there are real legal risks in many of these products – often with the issuer having the right to terminate the product and suspend capital protection in the event of market disruptions. But isn’t that exactly the time when investors’ would want their capital protection to be in place?

Misleading and deceptive marketing

ASIC was particularly critical of products where the structure and legal documentation hides the real components and/or risks of the transaction. Paragraph 115 of the ASIC report states:

“we are concerned that it may be misleading or deceptive to describe certain ‘synthetically geared’ products as entailing a loan and loan interest payments, if the product does not entail a ‘real’ loan but offers leveraged exposure created through derivatives, especially if this is not explained.”

This comment relates to the Macquarie FLEXI 100 product, which uses exactly the type of structuring that ASIC refers to. In my Eureka Report analysis of FLEXI 100 (Investment Road Test: Macquarie Flexi 100, published April 30, 2012). I noted that the actual components of the product do not clearly appear from its PDS, and also that there are some adverse consequences that arise from its “synthetic” design:

“FLEXI is an example of a “synthetic” product, created using complex derivatives instead of real shares…Read [the ATO tax ruling for FLEXI] closely though, because it contains a couple of surprises: although the underlying investments offered by FLEXI are all linked to shares or sharemarket indices, all of the returns from the investment (including the final gain, if any, from movements in the shares or indices) are taxed as ordinary assessable income – far less attractive than the normal concessional CGT treatment for simpler share based investments.

“Further, although FLEXI 100 is marketed as a flexible investment which allows the investor to “walk away” part way during the life of the product (and in doing so, cease any liability to make any further interest payments), the ATO ruling insists that taxpayers should expect to stay in the product for its full term, and explicitly states that using the walk away feature can put at risk any of the interest deductions claimed up to that point.”

So, where to from here?

It’s not all bad news in structured product land. Often, the simpler the product, the more robust it is – and the more likely it will perform as expected. Right now, investors looking cautiously to re-enter the sharemarket with reduced risk, may find the simple “protected loans” to be useful. Providers like CBA and Macquarie have enhanced their offerings to provide interest rates on loans which are around the same cost as far riskier margin loans offer.

Of course, understand that the interest cost is a real cost (i.e., it’s not part of the protected outlay), but at least these loans are used in conjunction with real shares, paying real dividends and franking credits – and with discounted CGT applicable at the end of the loan.

The ASIC report is written in plain English and sets out its findings very clearly. Unfortunately, the ASIC report doesn’t refer to products by name (for specific product analysis, you can refer to my Eureka Report reviews), nor does it cover ASX-listed products (like the popular range of instalment warrants). It’s a must read for any serious investor looking for ways to limit their investment risk.

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services. He is also a portfolio construction manager for BetaShares.