Too good to be true?
Explaining a participation rate of 150%
Janine Starks
Head of Investment Solutions
Question: A fund which gives 1.5 times the rise in the markets, with full protection seems too good to be true. How do I explain this to investors?
Answer: I agree, when you offer a fund with accelerated growth in the sharemarket and a massive reduction in risk, it does look too good to be true. It's a case of "heads you win more, tails you get your money back". Investors will of course question this and rightly so. For years they've invested in funds which give them all of the rise when the markets go up and all of the fall when they go down. When we improve the usual risk/return payoff, it's not surprising that they want to know how we can do it.
1. Explain the 'participation rate'
Each time we launch a new protected investment the participation rate can change. For example, in the past, Liontamer have launched similar funds which offered 85% of the rise in the sharemarkets and others offering 100% of the rise. It's often easier to understand when there appears to be an obvious cost to capital protection i.e. if you get 85% of the rise, then the cost appears to be the missing 15%. When the participation rate is 150%, it looks like a gain, not a cost, which adds confusion.
We need to educate investors that there are many technical factors which determine the participation rate. It is market movements and market conditions in a number of areas which cause the different participation rates.
2. Draw an analogy with fixed interest rates
When investors walk into their local bank, they
will see adverts for term deposits. They may
invest at 6% for a year and will lock in the
rate at that time. A week later they may return
to the bank and see that the new 1 year rate
is 6.5%. Movements in interest rates have been
driven by economic events and the rate is now
better. The bank was not 'ripping them
off' when rates were lower; there has simply
been a market movement. The same thing happens
with our participation rates. At some points
in time the rate will be low and at other times
we can offer very high rates - like now,
where we can give 150% of the rise with the GLOBAL
Series 1 booster units.
3. The factors which change the participation rate
Various factors can influence the participation rate. Here's a list of the main things with a short explanation:
- The level of stability or instability
in the sharemarkets - otherwise known
as volatility. When the markets are stable
(like
they are now), we can lock in higher levels
of participation for investors. When they are
very
volatile, it's more expensive and we
have to offer less.
- The term of the investment and NZ
interest rates: these two factors are intertwined.
To
create a protected investment, we need to put
the majority of the investor's money
on deposit with a bank for the fixed term so
it
will grow back to the original amount (that
way we are certain we can repay the investor
at maturity).
When the fixed term is longer and/or interest rates are high, we don't have to put as much money on deposit. This is because the deposit has more time to grow back to par and/or is earning a high rate of return. The less money we need to put on deposit, the more we have left over to go and buy "participation" in sharemarket growth. When we offer a shorter fixed term, or NZ interest rates fall, we have to put more of the investor's capital on deposit. That means there is less left over and we can't buy as much participation.
With our booster units, we are able to offer 150% of the rise in the sharemarkets over a 5 year term. If we wanted to, we could have offered a shorter 3 year investment and the participation rate would have dropped to 100% (still very attractive). In the world of protected investments, you should always see higher levels of participation as a reward for investing longer.
- Currency hedging: our funds are protected
in NZ dollars so investors don't face
currency risks. This is called 'hedging' and
there is currently a benefit available from
doing this. This benefit gets worked in to
the fund
and causes the participation rate to be higher.
It arises because NZ has higher interest rates
than the other countries in the global sharemarket
basket. The wider the differential, the more
benefit we can pass onto investors in the form
of a higher participation rate. If we issue
a new fund and we find the interest rate gap
closes
up, or reverses, this would cause our participation
rate to be lower.
- The level of dividends: with a protected
investment, your return is based on the growth
in the capital value of a sharemarket index.
You don't earn the dividends from all
the shares in the index. The theoretical value
of
the dividends gets put into our formula and
affects the participation rate. With some indices,
investors
are giving up very little dividend e.g. with
the Japanese Nikkei Index it's less than
1% p.a. With the UK's FTSE 100, the dividends
are over 3% p.a.
- In summary: right now we have very stable sharemarkets, high NZ interest rates and a wide differential in interest rates between NZ and other countries. These three factors in particular mean that the pricing of protected investments is very attractive. These conditions have significantly increased the participation rates we can offer.
4. Explain how a protected investment differs from a traditional fund
For some investors explaining the four factors
above and how they inter-relate is quite complicated.
It could be easier to keep things simple and
point out the differences between a protected
investment and a traditional fund. This helps
an investor to see the advantages and disadvantages
of both.
| Protected investment (Example: Booster units) |
Traditional tracking fund | |
| Protection | Capital protected at maturity, so if the markets fall in value, investors don't lose money | Not protected, exposed to market falls |
| Term | Fixed for 5 years. Not capital protected if you withdraw early. Cannot add to original investment | Fully flexible, you can withdraw whenever you like and add to your investment when you like |
| Growth rate | Current fund: 150% of the rise in global sharemarkets (not including dividends) | 100% of the rise plus dividends |
| Tracking error | No tracking error, perfectly tracks each index | Depends on partial or full index replication
as to level of error. Full replication can add excessive transaction costs |
| Dividends | Not paid. Small annual distribution of 0.05% paid | Paid to investors or accumulate |
| Currency risk | None, hedged back into NZ dollars | Fund maybe fully exposed to currency risk. This can work in the investor's favour or cause significant losses. Currency risk adds an extra dimension of risk to the investor's exposure |
| Management fees | 0% p.a. | Fee paid will depend on the fund |
Important notes about Global Series 1 booster units: This article is for information purposes only and is only a brief summary of the key facts. Full details are contained in the Investment Statement and Prospectus, which can be obtained from your financial adviser or Liontamer Investor Relations on 0800 210 451. Although the Note Issuer (Barclays Bank PLC) is legally liable to repay the investments owned by the trust and all returns on those investments, neither the Note Issuer nor any other entity guarantees the repayment of units or any returns on the units, nor accepts any other liabilities to unitholders. Past performance of the sharemarket should not be used as a guide to future performance. The final level of the Liontamer Global Index is averaged in the last year of the term. This aims to protect you from sharp falls at the end of the term. In a rising market averaging lessens returns.
