A piece of the action

Capital-guaranteed funds have been booming in Europe and Asia, but Australia’s institutional and retail investors alike have so far been reluctant to invest in these products. Mia Trinephi reports

Capital-guaranteed funds have thrived in Europe and Asia over the past two years, as plummeting interest rates and sluggish stock markets have prompted investors to seek protection for their investments, while at the same time allowing them to cling on to the coat-tails of any upward performance in the equity markets. Efforts to introduce capital guaranteed funds in Australia, however, have been met with relative indifference. But this hasn’t deterred a handful of banks from taking a keen interest in the product, while some are working on new structures that could remove some of the hurdles to lure investors.

The success of capital-guaranteed funds elsewhere around the region has been staggering. In Hong Kong, for example, a 25% dive in the Hang Seng Index combined with diminishing savings rates of 0.125% prompted investors to plunge $3.8 billion into capital- guaranteed products last year, accounting for 90% of the fund industry’s net sales. In Australia, however, only a handful of funded capital-guaranteed funds have been launched, while adverse tax treatment has led to dwindling interest in those available, say observers. Although capital-guaranteed funds do not pay out annual dividends, investors still have to pay taxes on the estimated income, or accrued interest, every year.

The traditional funded capital-guarantee structure usually has around 90% of the funds invested in zero-coupon bonds, therefore ensuring the 100% guarantee at maturity. The remaining 10%, minus management fees, is used to purchase options typically on an index or a basket of stocks, which accounts for the potential upside.

However, only one player has launched this form of capital-guaranteed fund structure in Australia. SG, the investment banking arm of Société Générale, launched the fourth series of its capital-protected equity-linked securities (Capels) in July. The fund offers a 100% guarantee over five years, with a possible upside linked to the performance of the S&P 500 index. The index performance is calculated on a six-monthly basis, and investors can achieve the upside of the index, capped at a maximum of 7.5% for each measurement period. There is also an Australian dollar/US dollar exchange rate guarantee built into the structure and no management fees.

SG’s three previous funds, starting with the first fund issued in June 2001, have been linked to a basket of 10 international stocks, the Dow Jones Global Titans Fund and the S&P/ASX 200 respectively. But each fund has been met with mixed interest, attracting around $10 million per issue. Sydney-based Suzanne Salter, head of equity derivatives at SG, points out that each Capels issue is getting larger, reflecting a growing, albeit modest, appetite from investors.

However, the main hurdle is that investors who put money in a funded capital-guaranteed product have to pay accrued interest tax every year. Therefore, if the performance of the underlying investment doesn’t yield enough return at the end of the life of the capital-guaranteed fund, investors may lose money because of taxes, management fees and inflation, some bankers say. “The Australian fiscal treatment of non-leveraged capital-guaranteed products is not at all favourable because of the taxation of accrued interest,” says Jean-Michel Ritoux, head of equity derivatives at BNP Paribas in Sydney.

SG includes a tax opinion from its legal advisers Baker & McKenzie in the offering circular to explain that the Capels are subject to capital gains tax rather than accrued interest taxation. Consequently, capital gains tax is payable at maturity, or upon disposal of the investment, rather than annually as is the case of accrued interest tax.

However, observers point out that opinion doesn’t necessarily reflect the position of the tax authorities and that as long as there is no specific ruling from the Australian Tax Office, the Capels’ tax treatment will remain uncertain, especially given that they are the first product of their kind in Australia.

In addition, given the current downward direction of stock markets globally, the traditional capital-guaranteed fund structure is difficult to justify, say some. If the index or basket of stocks remains flat or drops below a certain level, the investor may just get the return of the zero-coupon bond. The capital may be guaranteed, but the investor would have paid management fees for little or no return.

In fact, volatility levels have been low in Australia, meaning that there is little potential pick-up from the option component, says Greg Mackay, executive director and head of equity markets Australia at Macquarie Bank, in Sydney. “The Australian market overall hasn’t had the volatility that the Hong Kong market has experienced,” he says. “There is sub-10% historical volatility, and implied volatility has not been much over 10% even going up to six-months.”

In Hong Kong, houses have attempted to circumvent this problem by developing exotic structures involving options such as reverse cliquets. Here, the fund starts off with a high initial payout, say 100%, and any negative performance in the underlying index is deducted over the life of the fund. So, if the underlying index or basket of shares falls by 70%, the investor still receives a return of 30%, plus the initial capital outlay, leading to a payout of 130%. If the market remains flat over the life of the fund, the investor still receives the maximum payout. However, in Australia, investors’ conservatism combined with the higher cost of exotic option structures, has led institutions to shy away from these funds.

Nonetheless, there is interest from a handful of institutions to offer capital-guaranteed products and to find ways to offer funds that are not subject to the accrued interest taxation. Macquarie Bank, for instance, launched its Fusion Fund in May, which raised A$175 million ($96.76 million) in the six-week subscription period.

The Fusion Fund allows investors to borrow money to fund 100% of their investment, effectively making it a loan. The 10 different Fusion Funds are referenced to a pool of funds, from firms such as Colonial First State and BGI, and if the value of the fund at maturity exceeds the initial loan, investors keep the gains. If the value of their investment is lower than the initial loan, investors can use whatever proceeds there are from the investment to pay back the loan with no need to pay back the outstanding amount, effectively giving it a 100% capital guarantee. And since investors pay interest on their loan, they can deduct their interest payments from their tax bills.

Macquarie is also planning to launch a product called Deposit Plus, which is effectively a discounted bond that has a return linked to the Australian All-Ordinaries index or the S&P 500, according to Mackay. “I think there is more conservatism out there, and we’re looking to pick up on that and offer more capital-protected products.”

Westpac also offers deposits linked to the performance of an underlying asset with a 100% capital guarantee. The participation and range deposits – the performance of the former is linked to an underlying asset, the latter gives a greater yield if the underlying asset remains within a defined range – were launched earlier this year, and the bank is looking to widen the availability of these products to a broader customer base, according to Stephen Eakin, head of equity derivatives at Westpac in Sydney. “We are reviewing that at the moment to actually roll them out through external distribution and a wider customer base,” he says.

Westpac is also keen to develop its expertise in providing capital guarantees. The bank has already provided the capital guarantee on OM Strategic Investment’s OM-IP fund of hedge funds, and is currently looking at “building our capability to offer capital guarantee’s over other funds”, says Eakin.

The bank’s plans have been given a boost by the acquisition of Rothschild Australia Asset Management in April. The deal to join the two companies’ fund management businesses into a single unit was completed in early June, and will combine Rothschild’s 1,000-plus financial advisers with Westpac’s 765 financial advisers and planners.

In fact, the fund-of-funds and fund-of-hedge-funds product is where some see the future of capital-guaranteed funds in Australia. Observers say a 10% return would justify the costs and management fees of a capital-guarantee structure and, at the moment, hedge funds seem to be the answer to underlying higher returns.

However, hedge funds are often associated with Asia’s meltdown during the economic crisis. As such, the protection of a capital guarantee makes the fund-of-hedge-fund structures more attractive to retail investors, says Westpac’s Eakin. “If the underlying funds of the capital-guaranteed fund have a history of solid returns but are viewed as risky, retail investors would be prepared to pay for the capital guarantee.”

OM Strategic has more than A$2.3 billion under management in alternate investment funds. The first OM-IP fund was launched five years ago, raising A$30 million and OM Strategic is preparing to launch its 14th fund, the Series 8/OM-IP 220, and reckons it can raise A$200 million within six weeks. John Morrison, head of fund of funds at OM Strategic in Sydney, says: “The key to the success of a fund is performance.” Ritoux at BNP Paribas agrees. “The performance of the underlying investment has to justify the cost of the capital guarantee,” as well as the cost of the loan in the case of protected margin lending, he says.

The OM-IP is referenced to a collection of hedge funds, and the core investment is UK-based Man Investment Product’s AHL Diversified Programme, and Chicago-based Glenwood Group’s Multi-Strategy programme, which has exposure to 90 funds. “The capital guarantee certainly helped the success of the fund,” says Morrison.

Meanwhile, Colonial First State Investments is also offering a fund-of-hedge-funds product to the retail market – although without a capital guarantee. Colonial’s Global Diversified Strategies Fund was launched in October last year and currently manages A$80 million with exposure to 25 hedge funds. Observers say the fact that a traditional fund manager such as Colonial is entering the hedge fund market means that there is potential for the fund-of-hedge-funds concept in Australia.

However, with or without capital guarantee, market participants say that risk aversion by Australian investors will slow down the growth of those products for the time being. Australian “investors are more risk averse than overseas investors; they’re more advisor-driven,” adds Andrew Baker, Sydney-based head of products at Rothschild Australia Asset Management.

Financial planners “are embracing the concept of fund of hedge funds”, but “we still have a long way to go” in educating Australian financial advisers and investors on hedge funds, adds Damien Hatfield, who joined Colonial First State Investment last year to head its hedge fund group.

But once investors are more comfortable with hedge funds, the funds will probably have more potential to grow, market players say. Asset consultants currently put about 5–7% of their portfolio in alternative investments, compared with between 10% and 15% in the US.

One way to familiarise investors with the product is to allow them to try out the investment with a limited exposure. Colonial’s retail fund of hedge funds has a minimum investment of A$1,000. As a result, 65% of the fund flow comes from small investors, says Hatfield. The small minimum investment requirement allows investors “to get an understanding of the fund and hedge funds in general prior to committing more money,” that is, it allows them to decide whether it is the right investment for them before they commit larger funds, Hatfield adds.