Investment Road Test: CitiFirst MINIs

PORTFOLIO POINT: These MINIs offer sophisticated investors a great way of leveraging returns for relatively small outlays.

New technology can save time and improve our lives. ABS brakes, smartphones and keyhole surgery are all examples of innovations that have (arguably) contributed to making the world a better place.

Advances in financial technology can deliver similar benefits: witness the birth of the index fund, for example. But sometimes these developments are less about enriching our lives than lining the pockets of their makers, which is one of the key reasons we provide these “Investment Road Tests” – to give Eureka Report readers an unbiased perspective of the risks and benefits of new investments.

Before we launch into this today’s product, I’d like to cover off on a recent action from ASIC about a couple of products from JB Global that we have covered in the past (click here and here). This perhaps won’t be surprising to most readers, following the scathing reviews I gave each product at the time.

ASIC has acted to impose a range of sanctions on JB Global – a retail broking and advisory firm started several years ago by a former Macquarie stockbroker, Justin Beeton. We have never met Mr Beeton and don’t have any specific axe to grind about him or his products, but we do know that they don’t meet ASIC’s requirements for disclosure, and that ASIC thinks they have been mis-marketed to clients of JB Global (click here).

The specific investment in question offered exposure to Berkshire Hathaway for a low cost – through the embedded investment “loan”, which was mandatory, and which really was no more than the cost of a call option over Berkshire Hathaway shares.

Now, there is nothing intrinsically wrong with call options but when they are dressed up as a loan, with ambit claims made for tax deductibility of interest expenses and claims that the whole product is capital protected (when of course the interest expense is fully at risk), it’s always possible that ASIC (and perhaps the ATO) will become interested observers. It will be interesting to watch this story unfold – and to see how other, similar products are now treated – and we’ll keep Eureka Report readers up to speed as this happens.

For now, let’s return to the task at hand which is analysis of the new CitiFirst MINIs. These are similar (but with some important differences) to the MINIs issued by RBS and which we rated highly – four stars – when we reviewed them several months ago (click here).

The idea is to give investors a leveraged exposure to selected stocks and indices, for a lower cost than using traditional borrowing or derivative products. In bull markets these products are useful to multiply exposure to targeted stocks; and in a bear market like the one we are now in, they can be a great way to implement what we call “defensive gearing”.

We all know how attractive term deposits are right now – with one-year term deposit rates around 6.4%, investors can be seduced into ignoring the heavy impost on these returns made by inflation and tax. It’s the certainty of capital security that drives the appeal for many term deposit investors – compared to the uncertainty in the stockmarket, coupled with the meagre returns shares have produced for many over the past couple of years.

But the problem with ignoring our sharemarket is that it is CHEAP – with broad indices trading at price/earnings (P/E) multiples of 11 times, compared to average historical valuations around 15 times. Strong earnings from major stocks show that the depressed valuations are not reflective of earnings weakness – so they must primarily be reflective of concerns about the equity risk premium, being the price at which investors are prepared to invest in order to achieve returns which adequately compensate them for their risk.

Global market instability doesn’t help but we do know that the Australian economy and key blue-chip stocks have far sounder fundamentals than most of our developed nation counterparts. Investors should be shunning markets with fundamental problems, such as the US and Eurozone. Forget the biased claims of “long only” fund managers who have been calling for renewed investment in those markets – the predominance of evidence is that these markets are in a “secular bear” (long-term) phase. But savvy investors can and should be looking to create exposure to our market and key stocks, to profit when they recover or to profit from a stock that may be suffering from some weakness in its fundamentals.

Defensive gearing uses leverage to ration the cost of investment and to allow for a strong allocation of unspent money into term deposits or cash deposit accounts. For example, assuming a borrowing cost of (say) 9% pa, which is used to create a stockmarket exposure of $100, an investor could set aside $91 into a term deposit earning, say, 6.4% pa, and still end up at the end of the year with $96.82 (the term deposit plus accrued interest). In addition, if the selected stocks appreciate, this is in addition to the strong value of the term deposit position.

Here is where MINIs provide opportunity – because their leverage does not involve a loan to the investor, they are easier and often more convenient than a traditional investment loan to implement – and far less risky in a falling market than margin loans.

MINIs are created using call options (for a “long” investment) or put options (for a “short” investment). In line with the core idea of “defensive gearing”, which is to cheapen the cost of stockmarket investing (and thereby reducing the risk of loss in the case the market falls), MINIs use some simple and effective technology to reduce the cost of investing.

One of the benefits of Citi MINIs is that their pricing is simple to understand and transparent. Like all call options, a MINI is the right (but not the obligation) to buy (or sell) a designated share or index. The price at which the investor can buy the share is the “strike” price, and the cost of entering into the MINI is known as the “premium”. The price of the MINI is simply determined by subtracting the strike price from the prevailing share price.

For example, assume that the investor wants exposure to CBA shares, trading today at, say, $52.50, and the strike price of the MINI is set at $40: the price of the MINI will be $12.50.

One of the main reasons for using this approach (known in the options market as “deep in the money”) is to ensure that the MINI faithfully tracks the movements in the underlying share price. One of the problems with options is that they may not behave in line with those price movements – especially if the call option is very close to expiry, has an exercise price well above the current share price (known as “out of the money”) or if it has some features which limit its exposure to the underlying asset.

In fact, MINIs don’t have an expiry date – so they can be used for long-term exposures – and they have an embedded feature that limits the potential loss to which the investor is exposed. The risk of loss with MINIs is very simple – the most the investor can lose is the price they initially pay for the MINI – in the CBA example above, this is the $12.50 initial premium outlay.

To reduce the risk of loss (which would arise if the CBA share price fell by $12.50 or more), the Citi MINIs have a “stop loss” feature – the level of which is set 10% above the strike price of the MINI (in the case of the CBA MINI example, the stop loss level would be set at $44). If the stop loss level is triggered, Citi sells out its hedge and pays the net balance, if any, to the investor; this is a better result than simply letting the MINI become valueless in the event of a falling share price.

This means that the MINI expires if the CBA share price hits $44. Since these stop loss levels are relatively close to the prevailing share price/s, MINIs are most often used by investors who are actively monitoring or trading their portfolio.

They are a great way to leverage returns for relatively small outlays, and their price performance is stable and predictable. They should only be used by relatively sophisticated investors, who are able to monitor share price movements. As part of an approach to minimising risk and optimising stockmarket exposure, Citi MINIs are well worth a look. Oh, and their tax treatment is simple and reliable, too!

The score: 4 stars
1.0 Ease of understanding/transparency
0.5 Fees
1.0 Performance/durability/volatility/relevance of underlying asset
1.0 Regulatory profile/risks
0.5 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services with Alpha Invest but does not receive any benefit in relation to the product reviewed.