Investment Road Test: Macquarie Steps

This simple, low-risk way to increase market exposure is likely to appeal to investors who believe the worst is over.

PORTFOLIO POINT: Investors who believe the worst is behind us should consider this simple, low-risk way to increase market exposure.

Macquarie has launched a new series of investments (Macquarie “Steps”) which it has designed as a pathway for investors to begin to take more market exposure, under the guise of a relatively simple, short term capital protected investment.

The launch of Macquarie Steps is a somewhat optimistic endeavour from Macquarie, in that it expresses the view that the recovery will occur, and that Macquarie wants to be at the leading edge of investment providers as it happens. For many investors, now may not yet quite be the time to resume “full” exposure to risky investments, and the design of Steps tries to take that into account.

Steps is issued as a deferred purchase agreement, with a choice of investing into ASX 200 exposure, a basket of Asian stockmarket indices, or into exposure to the PIMCO Global Total Return Fund. More choices are expected to be offered in later series of Steps. Terms offered are either two or three years, (depending on which asset class is chosen), with returns either subject to a quite generous cap, or uncapped. No dividends or distributions are made during the term, and at maturity the returns are paid in the form of delivery of ASX listed shares (which the investor can elect to be sold and receive cash proceeds instead).

Just pausing there, what is immediately refreshing is the absence of complex formulas linked to the underlying participation or exposure to the underlying assets, and also to see that Macquarie has chosen not to weaken the investment by paying out interim distributions during the investment term. These factors are relevant because the structure of Macquarie Steps is based around derivatives, which are used to hedge the risks involved. When derivatives are being used, they can all too often be complex and offer relatively trivial real investment exposure.

Typically this happens when the overall product is being used to support gearing strategies, which, as prudent investors will know, can only be tax-effective when the investment produces regular income streams that support tax deductibility of gearing interest costs. When derivative-based products try to provide for regular distributions, this is always at the expense of the real returns investors can expect from the product as a whole, and often this is the trigger for the provider to “tweak” what’s left in the product by using complex payoff profiles and formulas to try to overcome the shortfall.

Unencumbered by the baggage of structured gearing arrangements, how has Macquarie fared with its new initiative into Steps? Overall, the simplicity is likely to be attractive to investors, who can choose from ASX 200 or Asian exposure with a cap in the range of 145% to 180% (the actual cap level is set on the final issue date for each series; the dates are clearly set out in the PDS and Term Sheets, which are available online). Another very interesting option accesses the superbly performing PIMCO Global Total Return Bond Fund (this has been generating cracking returns since the pits of the GFC) and the PIMCO series of Steps does not have any performance capping.

The technology enabling these types of investment products isn’t new; it uses a combination of derivatives (call options) and bonds to create exposure to growth in the underlying asset (via the call option) and to provide cash to cover the capital protection at the maturity of the product (via the bonds). The package itself (the “deferred purchase agreement”, or DPA) is also routinely used for these types of products, and has the comfort of generic tax office ruling, which specifies that there is a CGT event at the maturity of the product. (These ATO rulings on deferred purchase agreements have been stretched with some exotic forms of DPA, but should remain applicable in their current form to simple DPA products like Steps).

DPA investors typically should focus on the size of their exposure to the underlying assets (which, as we saw above, is relatively simple and clean in the case of Steps), as well as looking out for any exotic provisions that would trigger an early maturity of the product, and also carefully consider the credit worth of the issuer (relevant both to the payment of any gains as well as to the repayment of the investor’s capital at maturity).

DPAs typically provide for a number of scenarios in which the product can terminate prior to its stated maturity date, and if these “early maturity” events occur, it normally also means that the capital protection in the product also ceases to apply. The PDS for Steps provides a typically long list of events which could trigger an early unwind of the product, including (“we” refers to Macquarie in the following list):

  • We are unable to acquire, substitute, maintain, unwind or dispose of, or realise the proceeds of, any transactions or assets we consider reasonably necessary to hedge our risk of providing you with a DPA.
  • We have incurred, or will incur, a materially increased cost in either acquiring, substituting, maintaining, unwinding or disposing of, or realising the proceeds of, any transactions or assets we consider reasonably necessary to hedge our risk of providing you with a DPA.
  • There is an announcement that a Reference Asset (or a Reference Asset Constituent forming part of a Reference Asset) for a DPA will be de-listed or have its trading status withdrawn from any Relevant Exchange.

In a “normal” market, these types of clauses should be recognised, but for large and liquid assets like the ASX 200, they can normally quite safely be considered as practically inapplicable. Certainly, using large and liquid indices like the ones chosen for Steps, provides high levels of comfort (eg, the indices should remain open and functioning even in extreme scenarios); compare this to the far higher risk where individual stocks are referenced.

But the devil is in the detail and potential investors in Macquarie Steps should realise that these early maturity provisions would give Macquarie the ability to unwind the product early (eg, without capital protection applying) if its costs of doing business and hedging rise “materially”. Given the direct link between economic uncertainty and bank’s costs of capital, there is real possibility that this clause could become operative.

Unfortunately, until the final price and specifications are determined on the date of issue of each series (eg, specifically the capping level), it isn’t possible to assess Macquarie’s fees and profit margin. In addition to the internal profit margins, Macquarie can charge an establishment fee of up to 2.2% if the investor uses a financial adviser and agrees for the fee to be paid to them.

Macquarie Steps provides a relatively simple and easy-to-understand investment, designed for those who feel the worst of the global market uncertainty is behind us. A final note regarding liquidity: Macquarie only permits early withdrawal twice a year, which may not be sufficient for many investors.

The score: 3 stars
0.5 Ease of understanding/transparency
0.5 Fees
0.5 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.

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