Using Structured Products in a cautious Portfolio

The Value of Guaranteed Equity Bonds

David Stuff, Barclays Capital

Why are guaranteed equity linked bonds (GEBs) not considered a core component in portfolio construction? Ignorance plays a part, but a lack of appreciation regarding how a guaranteed equity bond fits with the investors' attitude to making and losing money is also important. Including guaranteed equity bonds in cautious investors' portfolios provides them with a mix of protection and exposure that a portfolio based exclusively on equity and bond funds cannot match on its own.

In order to identify how valuable an investor would find a guaranteed equity bond versus the more usual equity fund it is necessary to go back to basics and evaluate an investor's appetite and attitude to risk.

In this instance we need to determine whether a cautious investor wants a low risk portfolio, or a portfolio offering a more mixed approach to risk exposure. For most investors, risk is viewed in terms of the possibility of losing money, and as such, many investors will be seeking capital preservation. Ideally, such investors they are looking for a better return than they receive by placing the cash in the bank, and most don't want to end up with less than they started with in the first place. Crucially, any analysis completed needs to start at the fundamental level that each investor will have a different attitude towards risk..

A simplified way of looking at this is to determine how an investor would feel on a scale of -10 to +10 about making or losing an additional pound, with a score of 0 equivalent to getting their money back at the end of the investment period. A cautious investor may well respond like this:

1. How would you feel if you were to make an additional 1% per annum from your portfolio?
   "Well I would be happy, but then this is what I hoped for, so I would score it 2".
2. And how would you feel if you lost money, let's say that your portfolio were to fall by an additional1%?
   "I would be disappointed, as I now have less than I started with, so I would score it -7. It is this risk of losing money that stops me investing in the first place."

The cautious investor places a greater negative score on losses than they do on gains of a roughly equivalent size and I presume that most readers will recognise this type of attitude and approach to risk.

Without recourse to empirical study and using basic economics, we can harness the concept of utility to determine investor preferences and map out how impressed or disappointed investors will feel given the overall return from their portfolio. In this case, their 'emotional index' could be shown on a simple graph, displaying that the higher the percentage of return, the higher the level of positive emotion.

Source: Barclays Capital

This information shown in the graph can show how the guaranteed equity bond can be of real value to the cautious investor. The different values that the investor places on making and losing money means that a portfolio that includes guaranteed equity bonds will provide them with more of what they want and less of what causes them issues. The traditional solution to this problem would have been a portfolio with a lower equity content that would minimise the chance of losing money, but in correlation also restrict the chances of increasing capital return.

Let us now consider how the cautious investor will react to an equity investment versus the guaranteed equity bond. Utilising the emotion index, how will they value the returns offered by the two alternatives?

Assume the following two portfolios:

1. Equity portfolio with a 1 pc TER, dividend yield of 3pc and interest rates of 5pc with the investor expecting to hold the portfolio for at least five years.
2. Guaranteed Equity Bond (GEB) with 100% capital protection and 120% exposure to the growth in the FTSE 100 over 5 years.

(This is in line with the terms currently available on products from Woolwich Plan Managers and other providers).

The chart illustrates both the values of each portfolio given the value of the FTSE 100 Index at the end of the period, as well as familiar pay-off profiles.

• The fund benefits from dividends, and so will generate higher returns if the index remains around the initial index level.
• The GEB will be superior if the index either increases substantially, in which case the additional participation eclipses the loss of dividends, or of the market falls, in which case the capital protection built into the GEB, protects an investor from losses.

Source: Barclays Capital

The third step is to think about how probable each result is. Without the benefit of foresight we can assume a range of results, with a portion being good, and a portion being very bad, with the majority hopefully in the middle.

The following chart provides a forecast example of how much the FTSE 100 might grow over the next 5 years. The majority distribution is assumed to normally be placed around the risk free rate.

Source: Barclays Capital

The final step in the model is to combine the 3 above pieces of information that we now have.

Over the probable range of FTSE 100 returns, we can combine the value of the portfolio and the value that the investor places on their portfolio, as well along as the probability of the result occurring. This gives an overall score for the both the equity fund and the guaranteed equity bond. The mark for the equity portfolio is 0.39, but the mark for the guaranteed equity bond is 0.47, indicating that it is a better counterpart for the investor.

Source: Barclays Capital

This model has been over simplified but it should support the analysis that the guaranteed equity bond is a good fit for the cautious investor because they place a different value on gains, than they place on losses. Investors tend to be more concerned about losing money than making it. The investor who places a similar value on gains as losses is clearly more risk tolerant than the investor who is twice as concerned about losses as gains. For them, the equity portfolio would have a mark of 0.50?. The greater the difference, the more they will appreciate what a guaranteed equity bond has to offer. For example placing a value of -10 on losses does not change the score on the GEB, but reduces the score on the equity fund to 0.35.

The last variable to consider is the equity risk premium. A portfolio planner should question what positive return is expected from equities over the medium term over and above what can be earned from cash. Increasing the equity risk premium within a portfolio means there is less chance of losing money and this would lessen the appeal of the guaranteed equity bond. With an increase of emotion score sitting at 2:8, an expected equity risk premium of 3%, would generate a score of 0.81 for the equity portfolio and 0.83 for the guaranteed equity bond, so an investor is equally happy with either asset. If the equity risk premium were to increase further, the equity portfolio would be preferred.

Finally, we should also consider how realistic our spread of FTSE 100 returns is. Indeed, there are infinite numbers of more sophisticated models that look at how markets may move, but the important lesson to be drawn out of this model is that the guaranteed equity bond becomes more valuable to investors if the range of possible results increases. Increasing the spread of results in this model will increase the advantage that the guaranteed equity bond has over the equity fund.

No one would propose that the only asset in a cautious portfolio should be a guaranteed equity bond, but given the value that these assets potentially have for cautious investors, it is irrational to reject their application out of hand. These assets should play a part in every cautious portfolio, alongside the more traditional investments.

In summary, the guaranteed equity bond is suitable for investors who are more concerned about losses than gains, who think that the equity market will probably go up but not necessarily a lot, and who are worried about the uncertainty of equity returns.

The new generation of guaranteed equity bonds, such as those from Woolwich Plan Managers and other providers, are a far cry from the structured products of the past. Most offer high-quality secondary market liquidity if an investor wants to sell before the full term is up. The fit that the guaranteed equity bond has with the needs and attitude of the cautious investor, make these assets a natural part of their portfolio.