Investment Road Test: Linear SMAs

PORTFOLIO POINT: Linear’s new product almost, but not quite, offers the magic solution for capital protection in a volatile market.

For many capital-protected investments, the lapse last year into “cashlock” was a great disappointment, as the ensuing permanent allocation to fixed income meant that these investments could not participate in the equity market rebound that followed the global financial crisis.

As good investors understand, the disappointment should not be seen as a criticism of cashlocked investments, in that it’s the mechanism by which the all important capital protection is delivered. As one investor said to me recently, cashlock is simply the product doing its job.

Cashlock is a key feature of the protection mechanism known as CPPI (or constant proportion portfolio insurance), which prevents continuing exposure to falling price assets; think of it as an investment “line in the sand”.

But for investors who want to be exposed to the recovery prospects of markets after massive falls (hindsight is a wonderful thing!), CPPI is not the way to go. It is surprising, therefore, to see a new entrant to the SMA (separately managed accounts) market promoting its protected SMA, which uses a variant of the CPPI method, as being suitable for investors “tired of complex and opaque” investments.

The Linear “Continuously Protected SMA” was launched in June this year and offers three model direct share portfolios, one of which is provided by an early SMA participant the Ralton Group. Ralton was a participant in an earlier SMA platform, which was provided by BlackRock, and it’s interesting to see it re-emerge in another platform unassociated with BlackRock.

The Linear SMA offers an orthodox SMA approach (the beneficial holding of model share portfolios for investors, with direct reporting and account segregation unlike the pooled and tax ineffective technology of traditional managed funds). As a new entrant it’s too early to tell whether the Linear SMA will suffer from the clunky reporting that bedevils all existing SMA platforms to a greater or lesser extent. The novelty in the Linear SMA is the ability to select capital protection starting at 80% of the prevailing value of the chosen share portfolio, in a form that is claimed to be simpler and more robust that other methods.

The benefits of the Linear 80% capital protection include the ability to lock in profits continuously, and the flexibility of no set maturity date for the capital protection mechanism. Fees and charges are not exactly cheap but compared to the likes of AXA North they are not at the top of the range either. It’s unfortunate that investors are exposed to brokerage costs, albeit modest; these should be zero for an account with access to wholesale rates.

JP Morgan is the provider of the capital protection technology and with an all up cost of between 1.49% and 2.26% pa, the overall costs are acceptable. Financial advisers can add entry and ongoing service fees, which investors can avoid by investing directly.

Despite these benefits, the Linear SMA will suffer from rapid deleverage (allocation to fixed income assets) in a rapidly falling or gapping market. This allocation is determined by the computerised risk management technology behind the protection method, which is no easier to understand than more traditional CPPI methods in volatile markets.

Although it’s unlikely to enter into permanent cashlock, the pace of recovery in the Linear SMA after a crash will be slow. For investors looking for a magic solution to the problems of capital protection in a volatile market, the Linear SMA offers some, but not all, of the answers.

The score: 2.5 stars
0.5 Ease of understanding/transparency
0.5 Fees
0.5 Performance/durability/volatility/relevance of underlying asset
0.5 Regulatory profile/risks
0.5 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online, a provider of investment training to financial services professionals.