Investment Road Test: BT Wrap Capital Protection

What a week (month) it’s been in the Australian sharemarket. Our stockmarket has fallen more than 400 points since its highs this year, after trending sharply down when US Fed Reserve chairman Bernanke mentioned the possibility of the unwinding of quantitative easing. Consider these risks:

• Behind the global collapse in share and other asset prices (gold is down 25% from its highs) is the profit-taking by the “global macro” arbitrage players (investment banks and hedge funds), which have been using cheap money to set up massive long/short plays.
• The approaching end of cheap money makes the fuel for this arbitrage more expensive, as well as turning around the price momentum in the assets used in these plays.
• Bond yields are rising (meaning bond prices are falling), and the spotlight is back on the fundamentals behind each asset class.
• In Australia, our rapidly weakening economy is teetering on the brink of deflation (with underlying inflation ex the impact of the carbon tax now running at 1.8% pa – below the Reserve Bank’s comfort zone of 2% pa), pressuring our currency and sharemarket.

Uncertainty is creeping back into investors’ psyches, and may be here for some time yet.

Enter the BT Financial Group’s new “Wrap Capital Protection” facility – a timely solution for investors nervous about the value of their investments (click here). The BT Protection facility attacks the most fundamental of all problems for investors – when investment uncertainty dominates markets, investors shy away from risky assets like stocks and seek the security of cash deposits.

This is never a long-term solution, because the returns from cash typically are insufficient to provide for an adequate retirement. This is particularly so now with Australian interest rates at 20-year lows and expected to be close to 2% by year-end.

If staying out of the sharemarket isn’t a viable long-term solution, but staying invested creates the problem we now know as “sequencing risk” (losses are more serious for older investors than for early stage wealth accumulators), the need for capital protection becomes profound.

Put option-based protection is expensive

The AXA North investment platform is an early example of post-GFC attempts to provide convenient and robust capital protection. In my investment road test of the AXA North facility in 2009 (click here) I noted that “…it’s the potential for massive fees and charges across the entire AXA North product that will, in practice, make the facility unattractive for well informed investors”. The AXA North protection facility scored at 1.5 stars (out of a possible maximum of 5 stars).

Despite the certainty available with the “hard” protection mechanism used in AXA North, it suffers from the problem typical with capital protection created using “put option” technology – the cost imposes the need for high capital growth in order to break even. Unless that growth occurs, the erosion of the account value of the assets within the protection facility can, over the medium to long term, be just as damaging as a loss caused by a market crash.

Checking the current costs for AXA North shows this is still a problem for the capital protected version of this product. In addition to the basic costs of the AXA North platform, and the costs for the underlying funds which are selected, for a six-year investment term with a growth style asset allocation (e.g., with up to 63% allocated to Australian and international equities), total protection fees of more than 12.5% apply. Because of the “put option” style of the AXA North protection, investors are also required to lock into specific asset classes without the ability to change their asset allocation mix during the investment term. So although AXA North solves the capital uncertainty problem, it comes at the cost of a high fee load and a loss of investment flexibility.

Cash based protection – a cheaper alternative

Enter the new BT Protection facility, a creative application of a relatively simple concept, which sweeps money out of the protected assets into cash during market downturns. This technology has been around for several decades, but to date has suffered from significant inflexibility and problems for investors. It’s pleasing to see that BT has solved these problems and can offer what to date has been relatively exotic technology, with the ability for individual investors to tailor the way that their portfolio is constructed and protected. The all-up fee of 1.2% pa for the BT Protection facility means that over a six-year term it is nearly 50% cheaper than the AXA North protection facility – a significant cost saving.

The BT Protection facility has been designed in conjunction with the financial engineering expertise of Deutsche Bank, which provides a similar facility to UK clients. This is cutting-edge technology on a global scale – using what is known as “Individual Constant Proportion Portfolio Insurance” (“ICCPI”). The first generation CPPI technology has been around since the 1980s and was used in some of the high-profile structured products issued in the mid 2000s. First generation CPPI products used a “one size fits all” approach (where all investors’ portfolios are risk managed identically), and resulted in some bad outcomes for investors.

The beauty of the ICCPI technology is that it caters to the specific needs of each individual investor (hence the “I” in “ICPPI”) – allowing them to select the level and term for which their portfolio is capital protected, and also allowing them the flexibility to extend the term and to re-liquify their portfolio after a serious market crash occurs. In doing so, ICPPI technology overcomes the significant problems with old-style CPPI technology, creating a far more user friendly protection facility.

Overcoming the CPPI problem

The problem with the traditional CPPI technology is that the capital protection it provides comes with a key drawback known as “cashlock” – where the result of the risk management systems used in the CPPI technique is that all of the “risky” assets in the protected portfolio (like shares, managed funds, ETF’s etc) are sold down, with the funds realised being placed into a type of cash deposit known as a “zero coupon bond” (ignore the funky jargon – this is just a bond where annual interest payments are automatically re-invested back into the bond). The zero coupon bond grows in value so as to reach 100% of the initial investment value by the time the maturity date of the protection facility arrives.

“Cashlock” is a dreaded term, which first generation CPPI investors will be familiar with – it means that once the CPPI risk management systems kick in, the risky assets within the protected portfolio are permanently replaced with the zero coupon bond. This is a double-edged sword – although the investor’s capital is secure, the portfolio no longer produces any income or capital growth, such that ongoing income needs and the possibility of participating in a market recovery are both denied to investors in CPPI products that have entered into cashlock.

The ICPPI technology in the BT Protection Facility moves money out of the risky investment portfolio and into a zero coupon bond portfolio when asset prices fall, shown in Figure 1 below:

Click to enlarge

The innovation of the ICPPI technology in the BT Protection facility is that it allows individual investors to increase or decrease the levels of risk they are exposed to during the term of the protection facility, thereby avoiding the problem of cashlock:

• If the markets have fallen significantly such that the protection mechanism has sold down their risky investments in the client’s portfolio (hence moving the balance into a zero coupon bond), if the client subsequently desires to resume market/risk exposure, they can do so by extending the term of the BT Protection facility. This results in part of the zero coupon bond being sold down, with the realised funds available to go back into the risky investments;
• If the value of the investments have risen during the term of the BT Protection facility, the investor can lock in some or all of the gains, which effectively results in the sale of some or all of the underlying investments and the realised funds being moved into the zero coupon bond.

Investors can also choose to switch off the capital protection mechanism within the BT Protection facility at any time.

Conclusion

The BT Protection facility is a significant enhancement to the first generation CPPI technology, which bedeviled many products after the GFC. It mechanises the “risk on/risk off” trade which has become known as “dynamic asset allocation” – something which individual investors are capable of implementing themselves (by selling assets and moving into cash as markets fall, reversing this when market rally). The problem for most investors is knowing when to make the move out of risky assets and into cash – and because of the mechanisation in the BT Protection facility, this critical timing decision is implemented for investors and has the benefit of allowing for precise levels of capital protection to be selected.

Calculations for the BT Protection facility are conducted using Deutsche Bank’s risk management systems, which are licensed to BT for this facility. The investor’s ultimate credit risk is to the bonds that are used for the capital protection mechanism, which are issued by Westpac Bank. There is also a risk on Deutsche Bank, which sets up an interest rate swap mechanism to tailor the cash flows from the Westpac bonds to meet the specific amounts and dates for each individual investor’s portfolio.

All of these cash flows and transactions are managed using the reporting and administration systems in the BT Wrap service – which is only available through financial advisers. Fees for the BT Wrap service may be as high as 0.6% pa plus related adviser fees; although larger account balances will enjoy lower rates. For SMSF or DIY investors who don’t use a financial adviser, you should be able to locate an adviser who will provide you with limited advice around the BT Protection facility, for a reduced fee. Capital gains tax may be triggered when the risk managements systems sell down investments – a potential problem, especially since the funds from the sale will not be paid to investors (who will have to use other funds to pay any CGT liability).

Interestingly, BT has chosen to make its protection facility available only to customers of a financial adviser. Because of the power of the BT Protection facility, this is a strategically interesting move to lure customers back into a relationship with a financial adviser – how successful this will be remains to be seen. This is an elegant and low cost solution to a massive problem for all investors.

Tony Rumble is the founder of the ASX-listed products course LPAC Online, a provider of investment training to financial services professionals. He provides asset consulting and financial product services but does not receive any benefit in relation to the product reviewed. Twitter: @TonyRumble.