Fancy protecting your equity portfolio with an “airbag” against a market crash? Or maybe you prefer a “lock-in”? Or a protected tracker?
It’s all the latest market jargon, of course. But the products I’ve mentioned here, and others, have grown out of the covered warrants market that was launched in London in 2002.
For all of the hype that surrounded its launch, covered warrants and related products like this have mainly been the preserve of big institutional investors. They are another of the market’s well-kept secrets. But they are accessible to ordinary private investors too, and definitely worth a look.
Let’s just recap for a minute. Covered warrants are financial contracts rather like options, with strike prices, expiry dates and volatile prices. They are issued by investment banks on underlying securities and indices as diverse as consumer price indices, stock market indices like the “footsie”, the gold price, the oil price and some individual stocks.
The crucial difference between these and the plain vanilla options issued and traded on the EuronextLIFFE market, is that covered warrants and related products are traded on the London Stock Exchange and settled in CREST. So in theory at least, a call to your regular broker will enable you to deal in them.
The next striking thing is that, because these are one-off issues made by leading investment banks, they have in many cases been customised in attractive ways. This is where I think it gets interesting for Zurich Club members.
Let me explain. Most covered warrants are highly geared and volatile products. But there is a subset of financial products – known as certificates – that is rather different. These certificates are nothing to do with the old-style means of settling trades in shares and gilts, whereby you signed a transfer and pinned your share certificate to it when you wanted to sell.
New-style certificates are essentially products that track an index or some other underlying asset in a particular way. It could be they simply mimic the movement of the FTSE 100 index. Or it could be that the price tracks the “footsie”, but in reverse. Or it could be that it moves by double any index gain but just 1:1 if the index falls.
Capital protection limits your downside
Products are created using the principles that lie behind options. A straight 1:1 tracker is simply a call option with a strike price of zero, for example. A reverse tracker is a put option with a strike price so far above the index’s current value as to make it impossible for the index ever to reach it. The more elaborate the proposition behind the tracking certificate, the more complex the options used in its construction.
I don’t propose to go into the technicalities of all this. The key point is that many of these products are wholly or partially principal protected. That means that not only do you get some form of index-linked return, but your capital is protected from loss. And that chimes in with one of the key objectives of the Zurich Club – asset protection and capital preservation.
These products are broadly similar to the proposition inherent in some type of structured products marketed by insurance companies in the form of investment bonds.
The big difference is that certificates have liquidity. They can be bought and sold in the London Stock Exchange’s covered warrants market through a stockbroker. So if your circumstances change and you need to sell, you are not locked-in for a fixed period of time. It’s easy to sell, and trades are settled in CREST. The other very important point is that the minimum investment amount is relatively low, typically around £1,000 at the time of issue. So your investment can be as small or large as you wish.
Let’s have a look at a few of these products to see how exactly they work.
Lock-in your profits as the market rises...
Products like these are essentially similar to the Escalator funds launched by Close Brothers some years ago and constructed in the same way.
The basic proposition is that assuming the market rises, if you own one of these certificates it will lock-in, and protect, any gains you make once the index passes certain pre-set thresholds. In a product like this issued by Goldman Sachs, for example, the lock-in levels are 25%, 50%, 75% and 100% above the index level at the time the product was issued. In this particular case, the certificate (which has the stock code G993) tracks the DJ EuroStoxx 50 index. The reference level for the index at the time the product was constructed was 2,660. It currently stands at 3,933. The product expires in March 2010.
The eventual payout is the higher of the index value at the time or the highest lock-in percentage achieved during its life. The lock-in levels in index terms are 3,325, 3,990, 4,655 and 5,320. This represents respectively the 25%, 50%, 75% and 100% gain from the original starting point of 2,660. With the index currently at 3,933, this provides an interesting example of how the principal protection works.
The EuroStoxx 50 index has in fact traded as high as 4,100 in the recent past, above the 50% lock-in point of 3,990. Although the index currently stands below this level, anyone buying the product now is guaranteed to receive the payout linked to this lock-in level, plus any gains in the index above the 3,990 level that might persist in the future.
This doesn’t mean if you buy the product now that you are getting something for nothing, because with the product being traded in the market, its price will reflect the certainty of this return. In fact, now that the index has traded above the 50% lock-in point it is, in effect, principal protected at this level. So the price will stay at this percentage level until the index moves back up beyond it. Of course there is plenty of time left, another three years or so, for the index to move up and beyond some of the higher lock-in levels.
“Airbag certificates” provide partial capital protection
The way an airbag certificate works is not dissimilar to the way one works in a car. It will protect you quite effectively up to a point, but if the crash is a severe one, you can’t count on it.
Currently airbags are offered only on the Goldman Sachs Commodity index. In effect the product provides principal protection between 100% and 65% of the original issue price, 1:1 tracking of the index above the issue price. Below the lower protection level, the holder receives a percentage payout at the end of the term on a pro rata basis of the percentage amount the index ends up below the issue price.
So, for example, if the index ended up at 70% of the original index level, within the airbag range, an investor would get 100% of the issue price back. If it ended up at 60% of the original level, an investor would get 60% of the original issue price, because the index level is outside the airbag zone.
This brings up an important point. It is that all of the calculation related to principal protection is based on the levels, percentages and prices at the time of issue, not the investor’s purchase price. This is not necessarily to the disadvantage of the investor, but it does need to be borne in mind.
In the case of the airbag for example, with a current price around the 125% mark, there is downside risk to 100% before the principal protection kicks in. And as we’ve already seen, with a lock-in certificate, the terms mean that once an initial lock-in level is reached, the product becomes principal protected at the lock-in level.
Protected trackers – index performance and cash security
These are the simplest products to understand and usually give complete protection of capital in exchange for a return that represents somewhat less than 100% of the upside movement in an index.
The terms of products like this differ from issuer to issuer. One typical example pays out the greater of: 120% of the issue price, or the issue price plus an amount equivalent to 70% participation in the rise in the index between the level at issue and the average of the last year of the product’s life.
This particular product (security code GA88) expires in July 2010. In other words, it will give basic capital protection, a basic low single figure percentage return in the event the index doesn’t rise by much over the period, or reduced participation in any strong upside performance. Some protected trackers work in a similar way, but separate out these two elements on a more formal basis, providing a coupon-style return each year of their life and then an equity kicker that pays out at the end of the product’s life.
Which of these products you choose depends on your individual circumstances and the degree to which you want to manage your investment actively. Most protected trackers work best as “buy and hold” investments, but do bear in mind that the terms are based around the issue price, and not necessarily the price you pay.
Action to take: Decide whether you want the type of tailored protection that products like these can provide. Double check that your regular broker will deal in covered warrants (some do; some don’t). Review the terms of individual products in detail at the issuers’ websites. The main issuers are Goldman Sachs (www.gs-warrants.co.uk) and SG (www.warrants.com).
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