"it Is Our Choices That Show What We Truly Are, Far More Than Our Abilities"

By Author: Peter McGahan
Total Articles: 5
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"It is our choices that show what we truly are, far more than our abilities"

I wonder how this quote by JK Rowling sits with some of our bankers who bought ‘worthless debt securities'.

It is with this thought process in mind that I consider the next wave of ‘protected' investment products that are aimed at investors. I must say I am baffled by the statistics of people buying such plans and I can only assume they are reading the larger than large print rather than what the plan is designed to do.

The latest offering is quite a complicated one, but won't be sold to you as such. You will generally see it described as an investment that gives you the highest value the fund has been during its term. For example you are told to invest over five years and at the end of that you receive the highest value the investment reached over the five-year period. How could you possibly go wrong? How wrong could you possibly go?

These contracts use a mechanism called CPPI or constant proportion protection insurance. Before I give you the science bit, in short, they are, in my humble opinion, nothing more ...
... than twaddle, designed at taking in investments from investors who are scared of the current market, but haven't had risk explained to them

The science: CPPI ‘protected' contracts generally work on the basis of a quantitative risk based management process. You will have for example, a risky asset - equities, and a non-risky asset - cash. The ‘sale' is that you only get the highest ever value the fund had reached during the term.
The ultimate flaw with the product is that by definition it is designed to do exactly what you don't want it to do, and whilst the idea is ‘pretty' and easily saleable in a difficult market, the practicalities are such that a bucket of ugly, one legged frogs would be more useful.

In a rising stock market, they aim to provide a restricted level of growth due to reduced equity holdings, and ‘implied' protection on the downside. The plan is designed to daily adjust the balance between the equity and cash content, in reaction to the difference between the current value of the fund and its protected price. The system is never supposed to put more at risk than can be expected to be lost in a single day.

Sounds prettier if I say it that way. As the fund price rises, the gap between the current price and protected price increases, so more capital can be placed in equities. As the unit price rises, so too does the protected price, and this is continually ratcheted in. However the opposite also happens, where if the current price falls, the gap decreases and as a consequence more is placed in cash.
So let's think that through: You have to sell equities when they have gone down and then can only buy when they have gone up. Buy high sell low! How clever can that be?

More importantly there is also the risk that a sudden one-day fall, more than could have been really expected, would mean that the product could become fully cash-based and cash-locked, and the value could be below the protected level.

To cover this, gap insurance is supposed to kick in. However as we all know from the state of insurance providers of this ilk, such a fall would probably have put the insurance provider into considerable difficulty anyway, so is there any real protection?

The outcome is a cash locked fund, awaiting a return on the interest within it, at current low levels to drag the fund back above the protected level, in order to get an equity content again. Oh how wrong can this be?

However, the marketing literature is pretty, and you will find them on the high street, next to the frog shop. What would JK Rowling think?

For advice on investing for income or growth call Peter on 0845 230 9876 or e-mail info@wwfp.net

Peter McGahan is an Independent Financial Adviser and the Managing Director of Worldwide Financial Planning Ltd who are authorised and regulated by the Financial Services Authority. 'The FSA does not regulate Credit Cards, Will Writing and some forms of mortgage and Inheritance Tax Planning.'
Information given is for general guidance only, and specific advice should be taken before acting on any suggestions made.
The above represents the personal opinions of Peter McGahan.
All information is based on our understanding of current tax practices, which are subject to change.
The value of shares and investments can go down as well as up.

Peter McGahan is the Managing Director of Worldwide Financial Planning Ltd. Worldwide Financial Planning are authorised and regulated by the Financial Services Authority.
Visit http://www.wwfp.net/investment/investment-advice.html for more information about Worldwide Financial Planning and to find out more about Investment Advice.