Investment Road Test: Macquarie Bank Flexi 100

PORTFOLIO POINT: Macquarie Bank’s Flexi 100 capital protected product has high interest payments and the tax status is unclear.

Borrowing to invest can be a useful way to build wealth, especially for people who are “undersaving” and need to build their retirement assets. Most product providers offer gearing facilities as well as specialised investments that are designed to be used with borrowings. Capital protection, enhanced return and tax-effectiveness are the hallmarks of many of these specialised products. To the extent that a product delivers on this potential trifecta, investors can reap large benefits.

But these design features rely on financial engineering to deliver, exposing investors to key performance risks and the prospect of profits to issuers able to effectively incorporate the true costs and components of the investment. To appraise these types of investments we need to understand how they are created and priced, and to illustrate I want to look this week at the new Macquarie Financial Products Management Limited “Flexi 100” investment.

This is a 2.5 or five-year product with three choices of underlying exposure. Class A and B units provide exposure to the ASX 200 or S&P 500 index, with a minimum return of 4.5% pa at the end of each year as well as contingent return linked to the performance of the index. Class C units provide a variable exposure to the ASX 200 index linked to changes in the volatility of that index during the term, with contingent coupons up to 8% and fixed coupons totalling 10%. (For more information, click here.)

At present, the Flexi 100 investment can only be purchased in conjunction with a gearing facility provided by Macquarie at the rate of 8.95% pa payable annually in advance, which is suggested in the product disclosure statement (PDS) could be tax-deductible to investors.

Flexi 100 is described as a “capital-protected investment” – that is, the initial investment amount, which is borrowed, is protected and returned at maturity by the issuer. (In other words, at the very least you will eventually get your money back, in this case after four years.) The product seems to provide great benefits – all three of the trifecta are apparently available – so how does an investor assess the merits and true cost?

Start by looking at how these products can be manufactured. Look for a guide to the likely design and things such as the compulsion to borrow from Macquarie indicates that the embedded protection is likely provided by Macquarie in order to hedge its risk by purchasing a zero coupon bond matching the investment term, and using a call option to generate the exposure to the chosen index.

There are only two other ways to provide capital protection and neither can deliver the profile of the Flexi 100: if the protection was provided by the issuer purchasing “put options” (as happens with protected equity loans) the interest rate charged would be in the high teens (the higher rate includes the cost of the put option).

If the protection was provided by the “CPPI” method (otherwise known as “dynamic hedging”), it would not be possible to guarantee the minimum return, nor to guarantee that the product would remain exposed to the sharemarket index for its full term. CPPI involves active allocation between risky assets (the ASX 200 index) and bonds (which are purchased as and when the risky asset falls in value).

What's more, the product disclosure statement (PDS) for CPPI products have to declare that there is a risk that the investment can cease its exposure to the risky asset and become “cash-locked”. There is no such risk factor disclosed in the Flexi 100 PDS.

Analysing the C Class units, the actual cost of a 2.5-year volatility target option over the ASX 200 is about 8.5%. That amount is covered by the investor paying “interest” for the first year. The second and third (part year) “interest” payments is really where Macquarie will make a profit plus the cash for the minimum return of 10% paid at the end of year two (6%) and at maturity (4%) – which is therefore equivalent to a return of the investor’s original capital.

The loan taken out by the investor is recycled inside the product’s hedging to provide the cash used to fund the zero coupon bond which Macquarie creates: in an accounting sense the loan (an asset for Macquarie) is capable of being set off against the zero coupon bond (a liability for Macquarie).

Whether the tax office treats the whole package as a loan with deductible interest will be interesting viewing; in similar transactions in the past it has denied interest deductibility and applied penalties for borrowings of this sort. That occurrence would make the exercise significantly more risky and expensive than it seems to be.

The score: 1 star
0 Ease of understanding/transparency
0 Fees
1 Performance/durability/volatility/relevance of underlying asset
0 Regulatory profile/risks
0 Innovation

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