Protect yourself … like an institutional investor

In today’s market conditions, a cash and call strategy offers upside exposure for a set cost.

Summary: As the market falls, long-term investors looking to protect wealth can use a “cash and call” strategy. Products such as protected equity loans offer investors capped upside exposure for a set cost of purchase. Investors are also offered fixed downside risk and varying levels of flexibility.

Key take-out: The “cash and call” strategy is most likely to be useful for retirees who will eventually sell down assets to meet living expenses, and for pre-retirees looking to diversify their portfolio.

Key beneficiaries: General investors. Category: Investment strategy.

For investors who adopt the long-term buy and hold approach, a tension comes when confronted by the start of a market decline, as the fall has the potential to create some serious losses in a short period of time. Investors who buy shares directly (instead of through high turnover managed funds) can choose to ride out the storm – and for those with a sufficiently long-term investment horizon that will normally be the most efficient way to respond.

For investors already in retirement and for younger investors looking to protect some of their accumulated wealth, there are other ways to manage this risk. Taking profits and banking them can be a smart approach in conjunction with using some of the profit to pay for investments that operate like options on future market growth. This strategy is used by private banks and institutional investors in what is known as a “cash and call (option)” strategy, and can be extremely useful in conditions like we are currently experiencing.

There are two main scenarios in which the “cash and call” strategy may be useful, for part of the overall portfolio:

  • For retirees whose financial plans will require them to eventually sell down assets to meet their living expenses (i.e. who will at some stage enter “drawdown” phase), preserving capital value by taking profits can help prolong their quality of retirement
  • For pre-retirees/wealth accumulators, portfolio diversification will play a role in providing exposure to different asset classes – some of which will perform better than others over time (hence providing the rationale for that diversification). Compared to typical asset allocation guidelines, many investors with long-term share portfolios will right now be “overweight” the recommended exposure to Australian shares (as a result of good stocks doubling or tripling in value since the GFC). For these investors, taking profits has the twin benefits of bringing equity exposure back to “target” weighting, as well as limiting downside losses if markets continue to fall.

The obvious problem is the opportunity cost of selling down part of the share portfolio: what if the market performs better than expected? The cycle of fear and greed plays out strongly in the choices faced by investors in markets like the present!

Enter the “cash and call” approach

The “cash and call” strategy is a simple alternative to selling stocks and placing all the proceeds on deposit. Private banks and institutions routinely divert some of the proceeds of selling shares into buying call options which give them exposure to any upside, but which have a known and set cost of purchase. Call options require careful position management and so may not be suitable for retail investors – so this opens the scope for use of some of the leveraged products we have previously covered in Eureka Report. Products like the CBA Protected Equity Loan and Macquarie FLEXI 100 are being used by astute financial advisers and retail investors to create DIY “cash and call” exposures, in strategies which combine downside protection with exposure to share price appreciation.

Consider an investor with (say) $1 million in their SMSF, with half in shares and half in property. (This is a “concentrated” portfolio – so losses in either component will have a big adverse impact on overall wealth). Assume the investor sells down (say) $100,000 of their share portfolio and places the majority on deposit – buying say a one- or three-year term deposit paying between 3.60% pa to 3.90% pa. That $100,000 will be worth $103,600 after 1 year or $112,162 after 3 years (assuming interest is re-invested).

For a relatively small outlay, the investor can create exposure to $100,000 of sharemarket exposure using a product like the CBA PEL or Macquarie FLEXI. Here’s how it works.

Protected Equity Loan

We covered the basics of the Protected Equity Loan in Eureka Report on June 2 (see Is it time to gear?). These products are provided by most major banks and combine a basic interest cost, plus the cost of buying insurance against the share price falling, with a loan of up to 100% of the underlying share price. The investor can select from gearing levels typically between 60% and 100% (with higher gearing levels implying less capital is needed to be contributed to the strategy). Most PELs are eligible for use by SMSFs and, significantly, the investor is not liable for margin calls or for any capital losses (assuming a 100% loan to valuation ratio).

For example, current CBA PEL rates for a 100% loan over the StateStreet S&P/ASX 200 ETF (ASX code: STW) are 10.75% for a one-year PEL and 9.80% pa over three years for a three-year PEL. These raw costs are significantly reduced after dividends are received and after tax deductions and franking credits are taken into account. The cost includes payment for the insurance against the share price dropping, which in this example has been cheapened by the investor agreeing to “cap” their upside at a maximum possible gain of 12% (for the one-year term) and 25% (for the three-year term).

Using realistic assumptions about dividends and franking credits, the net after-tax cost for the CBA PEL over STW is:

  • $5,386 for a one-year term
  • $3,382 per annum for a three-year term

These figures are for an SMSF taxable at 15% pa. Individual investors receive more tax benefit for interest costs and hence their net after-tax costs are lower than for an SMSF:

  • $4,798 for a one-year term
  • $3,147 per annum for a three-year term

The best way to think about the benefit from a PEL is to consider the “return on investment” – because the PEL considered here gives exposure to $100,000 worth of shares, for a net after tax cost of $5,386 for one year or $3,382 pa for three years. If those shares grow in value by (say) 10% each year, the “return on investment” is extremely significant:

  • 74.08% for the one-year term (assuming the PEL investment is made by an SMSF in 15% tax mode):
  • 207.34% for the three-year term (for an SMSF investor).

On the other hand, if the market falls, the investor’s only cost has been the net after-tax cost of paying annual interest and insurance costs – and these will largely be defrayed by the interest earned on the cash deposit that was made at the start of the investment strategy.

In summary, after paying for the PEL, the investor’s worse case outcome (assuming share prices don’t rise during the term), would be:

  • If a one-year PEL is used, after receiving interest on the term deposit and paying the net after-tax costs outlined above, a net cash balance of around $98,000 would be retained from the profits taken by selling down shares of $100,000 at the start of the strategy;
  • If a three-year PEL is used, a net cash balance of slightly in excess of $100,000 would be retained.

This shows the power of the “cash and call” strategy: the investor has protected 98% of the value of the shares sold down (in the case of the one-year PEL) and 100% of their value (in the case of the three-year PEL) with the opportunity to generate a return on the PEL investment of between 74% to 207% over a one- to three-year term if the share market rises by 10% pa.

Macquarie FLEXI 100

PELs are available over Australian listed stocks and can be a very effective way to obtain leveraged exposure to those stocks. For investors looking for exposure to other stock markets or asset classes, the Macquarie FLEXI 100 product provides a similar profile to the PEL (with some important differences) with a wide choice of underlying assets:

  • ASX 200
  • ASX 20
  • International Equities Basket
  • EURO STOXX 50 Index

Further details are available by clicking here.

For convenience we will compare the FLEXI 100 offering over the ASX 20 stocks to the CBA PEL over the ASX 200 outlined above (the FLEXI 100 offering over the ASX 200 has a markedly different financial profile to the PEL – although there is no upside cap on the FLEXI 100 offer over ASX 200, it does not provide any capital return unless the underlying index rises by 20% during the investment term).

FLEXI 100 series “DP” has a 3.5 year term and provides exposure to the capital performance of the top 20 stocks on the ASX (the basket is equally weighted):

  • Amcor Limited AMC
  • QBE Insurance Group Limited QBE
  • AMP Limited AMP
  • Rio Tinto Limited RIO
  • Australia and New Zealand Banking Group Limited ANZ
  • Santos Limited STO
  • BHP Billiton Limited BHP
  • Suncorp Group Limited SUN
  • Brambles Limited BXB
  • Telstra Corporation Limited TLS
  • Commonwealth Bank of Australia CBA
  • Wesfarmers Limited WES
  • CSL Limited CSL
  • Westfield Corporation WFD
  • National Australia Bank Limited NAB
  • Westpac Banking Corporation WBC
  • Newcrest Mining Limited NCM
  • Woodside Petroleum Limited WPL
  • Origin Energy Limited ORG
  • Woolworths Limited WOW

Actual dividends are not paid on the investment (hence there are no franking credits attached to the distributions) but a cash distribution is paid at the end of each year, as follows:

  • Year one – 4.0%
  • Year two – 4.0%
  • Year three – 2.0%

FLEXI 100 is only offered in leveraged format – as a result, investors must borrow 100% of the cost of investment from Macquarie. The interest rate charged is 6.70% pa, which is tax deductible. Annual distributions are fully assessable. Unlike the CGT treatment of any gains on the PEL investment, any final gain on the FLEXI product is fully assessable. The cash distributions must be re-invested to pay interest for the following year.

In summary, the annual net after-tax costs of investing in this series of FLEXI 100 are slightly lower than for a similar PEL, with any final gain being taxed without the benefit of the concessional CGT treatment available for the PEL. Because of the cost similarity, FLEXI 100 can be used in much the same way as the PEL, in combination with investing in a term deposit to implement the “cash and call” strategy.

Key points

Each of these products provides fixed downside risk – in both cases, because there is no capital risk (assuming a 100% LVR PEL is used, ie there is no capital contribution from the investor) – the only cost is the net after-tax cost of servicing the loan used to buy the underlying assets. FLEXI 100 offers a regular “walk away” facility such that an investor can choose to exit the investment prior to its full term – and would be expected to do so if markets fell significantly (negating the opportunity of any eventual capital growth).

In the case of the PEL, the investor will be required to pay the insurance costs for the term of the investment – which means that for a PEL with a term longer than one year, the investor will incur break costs if they exit prior to the end of the loan term. For that reason, the additional flexibility of selecting a PEL with a one-year term may often outweigh the slightly higher annual cost of a one-year PEL compared to a three-year PEL.

PELs are relatively simple products, where physical shares are purchased and which pay dividends and franking credits. PELs typically involve some capping of the upside to defray the costs of insurance, but these caps will be relatively insignificant in practice (in normal markets). In contrast, FLEXI 100 is created using complex derivatives and many FLEXI series have performance hurdles which limit final payments unless markets rally strongly. Potential investors should carefully consider the impact of these features when selecting FLEXI 100 series, especially in respect of international equity indices.


Dr Tony Rumble provides asset consulting services to financial product providers and educational services to BetaShares Capital Limited, an ETF provider. The author does not receive any pecuniary benefit from the products reviewed. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.

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