PORTFOLIO POINT: Tax innovations and a 'walk away’ feature make this product attractive in the right market conditions.
Low expected returns appear to be one of the main reasons investors are staying away from the sharemarket. Coupled with fears of further downside, anticipated stock returns in the low single digits are driving the continued attraction of bank deposits and term deposits to many investors, according to investor research houses.
Even so, Australia remains caught in the headlights of recovery: we may well have caught the “Dutch Disease” (where high revenues from commodity exports trigger central bank monetary tightness/high interest rates), with some sectors continuing to demonstrate good earnings growth and resilient yields. The braver brokers are also calling for an increase in international equity exposure, prompted by the high dollar – which reduces the effective cost of buying overseas shares – and signs of economic recovery in the US.
Putting all these factors together suggests that an optimal way to invest in the sharemarket, here and offshore, would be to reduce the upfront cost of investment and reduce the prospect of loss in the event of market falls. These twin benefits are targets for Macquarie Flexi 100, which has been released for investment this year with some new features, compared to previous versions (see here).
Flexi has been around for a few years now, and the return history for previous series certainly shows some mixed results. Most series have performed poorly since inception – generally with the exception of some of the early series, which were issued when markets were on the cusp of recovery immediately after the GFC. This means that Flexi can work well for investors, when market conditions are conducive to it doing so.
Past performance data shows that Flexi does require a positive movement in the underlying asset selected in order to generate a positive return, so care should be taken when selecting specific assets. Because a variety of investment structures within the Flexi platform are available, care also needs to be used when selecting the style of investment; for example, some series don’t provide a return unless an investment “hurdle” is met, while others limit the upside by “capping” the returns at a pre-set level.
At its heart, Flexi delivers a payoff like a call option. That is, for a low upfront outlay, the investor has exposure to a much larger investment footprint, and the only downside that the investor can suffer is a loss of the initial outlay. (Read on for some tweaks to this general statement about some specific risks in Flexi). In return, if the underlying asset has risen in value during the investment term, Flexi will also appreciate in value, just like a call option would do.
The genius in the Flexi product is that investors receive the same tax treatment as would be available if ordinary shares were purchased with capital protection against downside risk, and with 100% gearing to help fund the cost of the shares. In other words, the annual outlay investors make when they buy Flexi is treated as a tax deductible expense, rather than as a non-deductible capital cost (as it would be if it was the cost of buying a call option).
Flexi is offered via units in a registered managed investment scheme (the Flexi trust). Each unit class has its own investment profile and choice of underlying assets. These include a simple basket of 20 ASX listed 'blue chip’ stocks, as well as US and Asian shares. Individual units are denominated in $100 lots and (here is the rub) can only be purchased using a 100% “loan to value” (LVR) ratio loan provided by Macquarie Bank. The loan can be limited recourse, in which case the only security given for it are the underlying units themselves, or full recourse. All units are capital protected (with the protection being sourced from Macquarie Bank), and the loan and units embed an innovative “walk away” feature, meaning that this capital protection is effectively available whenever an investor chooses to walk away from the investment. Flexi was the first Australian retail investment to offer this feature, which is at the heart of its financial design – and is delivered by using innovative derivatives as the hedging mechanism.
Macquarie also offers an “interest assistance” loan, which can be used to finance the investor’s annual interest cost, allowing for interest to be paid upfront and thereby creating a tax deduction for the investor as soon as the interest is paid. (We’ll return below to specifics of the rules which govern the timing of tax deductions for different types of investors). Investors can use their own funds to cover their interest expense, or can use the interest assistance loan to fund the interest payments. (The interest assistance loan is repayable monthly in arrears, principal and interest.)
Previous versions of Flexi have come with an interest rate of 8.9% p.a. This year, the interest rate has been reduced to 7.95% p.a., reflecting the declining interest rate cycle that we now seem to be entering, as well as being in line with falling market volatility, which is feeding into declining costs for the call options used by Macquarie to hedge the Flexi product. The relevance of option pricing can be seen by digging a little deeper to look at how Macquarie creates and hedges Flexi. For unlike some competitor products, which are packages of physical shares with related 100% gearing and capital protection, Flexi is created and hedged synthetically, using the techniques of the derivatives market.
Structured products like Flexi are created in the knowledge that there is economic equivalence between options and the assets to which those options provide exposure. Bear with us as we look at the relevance of the concept known as “put/call parity” – one of the most important and well understood items in corporate finance. Put/call parity tells us that the cost of buying a share plus a put option over that share, is always equal to the cost of buying a call option over the same share plus a bond issued by the same company:
s p = c b
(Where s = the cost of the share, p = cost of the put option, c = cost of the call option, and b is the price of a bond issued by the same company)
Looked at another way (recall your high school algebra), the cost of a call option over a share is equal to the cost of the share and an accompanying put option over that share, funded by a loan for the cost of the share and put option (where the cost of the loan is the interest rate):
c = s p - i
Don’t worry about the complexities of hedging derivatives or the “black box” which the derivatives market is to many investors. All that these equations mean is that there is an equivalence between borrowing to buy shares with protection, and the cost of a call option over the same shares. In both cases, the cost of the call option and the cost of interest are “wasting” assets – e.g. at the end of the term to which they relate, their value will have declined to zero, unless the value of the underlying asset has risen.
Put/call parity has one twist in the real world, where traders mark up the cost of a put option (compared to the cost of a call option) when they expect the market to fall, and conversely traders mark up the cost of call options when they expect the market to rise. It’s easy to understand why products like Flexi were created after the GFC using call option technology, rather than the far more expensive put option alternative; and when coupled with the reality that lending is now harder and more expensive for most banks, it can be seen why Macquarie has adopted the synthetic structure as a lower cost alternative.
It’s because of this “wasting” value that many investors shun the use of gearing or options as means to obtain exposure to assets. The cost of the option, or interest, represents a hurdle to the breakeven level of the investment, and unless the investor has reasonable confidence that this hurdle will be met, there is no rational reason to invest. Of course, that narrow logic loses sight of the benefit of using call options (or paying interest); namely, that the downside risk is reduced compared to paying the full cost of buying the underlying asset.
The magic in Flexi is that Macquarie has been able to create a call-option-like investment profile in the guise of a tax deductible interest payment. This hitherto unlikely result has been confirmed by the ATO, which has issued a product ruling confirming the deductibility of the interest cost for the loan which is used to invest in Flexi. Product ruling PR 2011/19 is in line with a previous ruling for Flexi, noting that upfront deductibility is available (up to a maximum of 1% over the RBA variable home mortgage rate) for individual investors, but that SMSF investors need to amortise/spread the tax deduction over the period to which the interest payment relates. For example, if an SMSF borrowed and pre-paid interest on (say) June 29 2012, it could only claim two days of the deduction in the 2012 tax year, and would then claim the rest of the deduction in the 2013 tax year.
The cap on the maximum amount available to be claimed as a tax deduction only applies to the “limited recourse” loan facility, since the full recourse facility does not fall within the ambit of the “capital protected borrowing” tax rules. The flipside here is that, if the capital protection provider failed, the investor using the full recourse loan facility would remain liable to repay the loan in full. In practice, this means that in the event of a Macquarie Bank failure, the Flexi units value would be less than their notional or face value, but the investor would be asked by the administrator of Macquarie Bank to repay the accompanying loan in full.
Apart from the obvious tax advantage of securing a tax deduction for the cost of entering into Flexi, the additional benefit is that this tax deduction lowers the effective cost of Flexi. Using the call option terminology we discussed above, this reduces the breakeven cost of the call option, thereby subsidising the investment outlay and, it would be expected for many investors, making the investment decision somewhat more palatable. Macquarie’s figures are that the breakeven cost of the basic Australian share series (series “BI”) is 1.95% p.a. after tax.
As indicated, apart from a wide choice of underlying assets, Flexi comes with a choice of two different terms (3.5 or 5.5 years) and with the choice of a contingent coupon paid at the end of each year, or with a fixed coupon. The contingent coupon is only paid if there has been a sufficient gain on the underlying asset, while the fixed coupon is paid without reference to any gain in the underlying asset. The fixed coupon may be seen as a return of some of the investor’s capital, because it is only paid after an investor has renewed the Flexi facility by pre-paying interest for the following year.
The ATO product ruling makes it clear that the tax deduction for Flexi’s interest cost can only be claimed where the investor has the intention of staying in the Flexi facility for its full term and thereby receiving all available coupons. The quid pro quo is that an investor who exercises the “walk away” facility, and exits prior to the normal maturity date, will put that tax deduction at risk.
The call option hedging mechanism passes through the cost of hedging to the investor, who pays interest to cover this cost. Because the interest rate is fixed for all Flexi series at 7.95% p.a., and because the hedging costs vary depending on the underlying asset, this means that the payoff for each series differs (reflecting the different hedging costs). For example, the 3.5 year Australian share investment (series “BI”) will not provide any maturity value to the investor unless the underlying reference shares have risen by 12.5% by the end of the 3.5 year term. Any gain above that is capped at a maximum of 65% and is enhanced by a factor of 1.4x (i.e. the gain is multiplied by 140%). Series BI also provides for payment of fixed coupons of a 5% p.a. for the first two years and 2.5% for the final year – so it can be viewed as trading off annual payments for part of the gain in return for a hurdle on the final payment. But don’t forget that the fixed coupons are only paid after investors have renewed their Flexi investment by pre-paying interest for the forthcoming year, so in that regard, the fixed coupon can be seen as a recycling of the investors’ capital.
Flexi contains some powerful financial and tax innovations. It can provide a positive return in the right market conditions. The investment cost is defrayed by the availability of tax deductions on the interest cost. Depending on which series is selected, the potential for returns may be limited by hurdles and/or performance capping. Given the tax novelty available in Flexi, investors should be wary of competitor products which do not come with the security of an ATO product ruling. The tax novelty is so great that the availability of an ATO product ruling should be seen as an absolute prerequisite before investing in this type of “synthetic” product. And because of the importance of tax certainty for this type of product, potential investors should carefully focus on any tax law changes in this year’s Budget, which could have an adverse impact on the tax status of this type of product.
The score: Macquarie Flexi 100 Trust – 4.0 stars
0.5 Ease of understanding/transparency
1.0 Performance/durability/volatility/relevance of underlying asset
1.0 Regulatory profile/risks
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.