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Defining portfolios

The management of client portfolios involves a continual decision making process. Whether it is a tweak to asset allocation or maybe introducing or removing an investment, we always try to stay ahead of the game.

For the most part, our portfolios tend to be focused on collective investments such as unit trusts.  We generally hold 20-30 funds in our portfolios to gain exposure to traditional and alternative asset classes. Each of the funds is carefully considered prior to purchase during our fund selection process. Mike Deverell discusses this in more detail in the latest copy of Equinox which you can read here.

As well as funds, we also invest a portion of money into what we class as ‘Defined Return’ products. They are a type of structured product that offer a predetermined return, given that certain criteria are met.

We currently have three products linked to the FTSE 100 in our portfolios. If, on any of the first six anniversaries the FTSE is at or above its starting level, the product will end at that date providing a capital gain. The potential return is determined in advance. For example, if the “rate” is 9%, the gain would be 9% if the product kicked out in year one, 18% if it ended after two years, 27% after three years and so on.

If the product fails to kick out on the final observation date, the full or partial capital is returned depending on final index level.  Our products have protection built in that allows for a 40% fall in the index at final observation date before any capital is lost.

As the products are issued by investment banks we are effectively taking on counterparty risk as well as market risk, i.e. that the issuer will be able to repay the amount due.  We carry out credit risk assessments on each of the issuing banks and also back test to understand the level of market risk we are taking.

Since October 2011 we have invested in 15 similar products created for us by 6 different investment banks.  Headline rates of return have ranged from 7.5% to 12.8% per annum, and all but two have been solely linked to the FTSE 100 (with those two being linked to both the FTSE 100 and S&P 500).

Our research tells us that, should history be repeated, the odds are stacked in our favour and that the product will kick out at some point during the six year term.  In fact, since 1978 about 75% of the time holders would have received the pay out after the first year and a further 10% would have received the return at the end of year two. 

Our studies also show that no FTSE 100 Index product with a 40% protection level would have suffered capital loss since 1978. However, there have been some instances where products would have just returned the initial capital, although this happened in less than 5% of past periods. In the majority of these instances the dividend income that would have been generated by holding an index tracking fund means an investor would have been worse off in a product.

The chart below shows the FTSE 100 index level throughout its history. The red shaded bars are times when products set up would not have provided a gain. The grey bars reflect when recent products have not kicked out yet but still have potential to do so (i.e. they have been set up in the past six years). Unsurprisingly the times we have not seen a kick out have focused around peak market levels:



We are eagerly awaiting the next potential kick out of one of our products on 2December. The Barclays FTSE autocall issued in December 2014 is coming up to its second observation point, having failed to kick out in year one.  If the FTSE closes above 6,742 next week the product will kick out, returning 18.3% for investors that purchased at launch. 

This would be a great outcome. As I write the FTSE is only just above the level required for kick out. Even taking into consideration the dividends they would have received, our investors are currently better off in this product than if they had bought and held an index tracker.  By illustration, if the product kicked out today, it would have returned 18.3%, more than double the return on the Index of 9.1% over the same period.

Given the potential kickout we have been going through the various options available to us.  If the market takes a dip the product might not kickout but if it does, what should we do with the proceeds?

Our current favoured option is to reinvest into another defined returns product. We are doing our homework early and have been busy liaising with our panel of investment banks, finalising our credit research and weighing up prospective returns on offer. We carried out our research based on index data from Thomson Reuters datastream and if you would like to find out more about the analysis we have undertaken just get in touch with our investment team.

From our research we are currently expecting to be able to secure a double digit annual return rate on a product linked to the FTSE only.  We see this as an attractive rate of return given our view that equity will return less than this in the short to medium term.

If markets move in our favour we should be in good position to take advantage of the opportunity to strike a new product at attractive rate.

The information provided in this blog is based on our opinion and is for general information purposes only. It is not, and should not be construed as financial advice. Investments may (will) fall as well as rise. Past performance is not a guide to future performance. Any performance targets shown are what we believe are realistic long-term returns. They are never guaranteed.