When we buy any investment I wonder how much do we really understand about the workings of the contract we are entering into?
In my experience investors are inherently risk averse. Investors are more concerned with risk than they are with reward. This sets them apart from speculators. To satisfy this demand, many investors are sold, and sadly buy, Tracker Bonds.
Tracker bonds – is the guarantee worth having?
The subject of investment risk for many people is considered a “bad” thing. Many savers therefore naturally tend to be attracted to products offering a capital guarantee. However, when we look a little closer, some of the tracker bonds on sale in Ireland today represent poor relative value to the investor. Yet consumers are not always given the necessary information to make informed decisions about tracker bonds according to the Society of Actuaries in Ireland.
One of the biggest problems is that investors are not able to assess the real charges. Due to the non-transparent nature of the products, the charges are concealed. Furthermore, investors do not consider the cost of the guarantee in their investment decisions.
The producer of the tracker will generally be taking charges of between 3% and 8% of the total amount invested in the product.
The terms of each issue vary, but will usually be for a minimum of several years and no withdrawals can be made during the term of the Bond resulting in an inflexible contract.
With tracker bonds, most of your money is actually placed in a bank deposit account and the remainder is invested in complex financial derivatives and/or options.
Dividends
Even if the return of a tracker bond is linked to a stock market index, the investor does not receive any dividends from the shares that make up the index.
Over the long term in a developed economy, dividends from equities have historically made up a significant part of the total return from a stock market investment.
A study in the USA by Ibbotson Associates into“Stock Market Returns in the Long Run”, concluded that the bulk of the long term return of the market is attributable to dividend payments and nominal earnings growth (including inflation and real earnings growth).
This suggests that the underlying share prices would have to fall significantly for the capital guarantee on a tracker bond to be worth anything at all. The loss of dividends is a very expensive price to pay for a capital guarantee.
Example Tracker Bond
I'm not picking this product out in particular, it just happens to be the one that I have in front of me right now and illustrates some of the pitfalls of investing in Tracker bonds. These pitfalls apply generally to all Tracker Bond products to a greater or lesser extent.
The disclosed charge in the brochure is 7.53% of the amount invested. This translates to an illustrated reduction in yield of 2.1%pa
However, the same page clearly points out that this is "a capital growth investment and will not benefit from any dividends"
Let's have a look at how much that might matter shall we by looking at the possible income yields on some of the underlying holdings:
I Box Euro Index - Yield 4.29% (source IBOXX Liquid Sovereigns Global 31st March 2008)
Eurostoxx 50 - Yield 3.5% (source Barclays 7/8/08)
EPRA European Property Index - Yield 3.62% (source Barclays 7/8/08)
So, you might be giving up around 3 to 4% each year in lost income on some of the holdings in the product. This is in addition to the charges! For the sake of balance, I should point out that there is no income on some of the underlying holdings (for example 25% invested is in commodities) and so overall you might expect to lose around 2 to 3% in income each year.
So in this example, I am down by around 4 to 5%pa in explicit charges and the implicit cost of lost income. Ouch!
Of course for all these charges, you have the peace of mind of a capital guarantee. 100% of your money will be returned on maturity or as the brochure points out, a guaranteed return of 0%pa CAR!
Let's assume you could obtain a net of Dirt return of 4%pa on your savings over the term of the investment, you have what is known as an "opportunity cost" of cracking on for 16% which is the interest you would have received if you had just left the money in the bank in the first place.
However, the guarantee is only there to stop you losing money. You are investing to profit from the markets right?
In this example, if the underlying investments appreciate, you will receive a cash bonus of 70% of the increase. So, for every 1% of capital appreciation on the underlying holdings, as an investor, you will in fact only receive 0.7%. Or put another way, a 30% "fee" is taken from your profits.
As I say, I'm not knocking this particular product it is simply a useful illustration of some of the issues, I'm sure there are worse examples out there........
Conclusion
They say there are two emotions that move the markets. One is fear; the other, greed. At the beginning of the cycle when the market expands, investors swing from fear to optimism to excitement to out-and-out greed. As the market peaks and contracts, investors shift from greed back to fear. Left unchecked, greed and fear can cloud rational, reasoned investment analysis and distort financial judgement.
This can leave us exposed to the risk of purchasing an investment which on the face of it meets our need for capital security, but which in reality is a relatively poor investment choice. For investors who are prepared to put in a little more effort, there are better ways of managing our conflicting desires for capital security and the best possible investment return than a standard off the shelf packaged product.
"The investor‘s chief problem - and even his worst enemy ' is likely to be himself"
Benjamin Graham, legendary American investor, scholar, teacher and co-author of the 1934 classic, Security Analysis
In my experience investors are inherently risk averse. Investors are more concerned with risk than they are with reward. This sets them apart from speculators. To satisfy this demand, many investors are sold, and sadly buy, Tracker Bonds.
Tracker bonds – is the guarantee worth having?
The subject of investment risk for many people is considered a “bad” thing. Many savers therefore naturally tend to be attracted to products offering a capital guarantee. However, when we look a little closer, some of the tracker bonds on sale in Ireland today represent poor relative value to the investor. Yet consumers are not always given the necessary information to make informed decisions about tracker bonds according to the Society of Actuaries in Ireland.
One of the biggest problems is that investors are not able to assess the real charges. Due to the non-transparent nature of the products, the charges are concealed. Furthermore, investors do not consider the cost of the guarantee in their investment decisions.
The producer of the tracker will generally be taking charges of between 3% and 8% of the total amount invested in the product.
The terms of each issue vary, but will usually be for a minimum of several years and no withdrawals can be made during the term of the Bond resulting in an inflexible contract.
With tracker bonds, most of your money is actually placed in a bank deposit account and the remainder is invested in complex financial derivatives and/or options.
Dividends
Even if the return of a tracker bond is linked to a stock market index, the investor does not receive any dividends from the shares that make up the index.
Over the long term in a developed economy, dividends from equities have historically made up a significant part of the total return from a stock market investment.
A study in the USA by Ibbotson Associates into“Stock Market Returns in the Long Run”, concluded that the bulk of the long term return of the market is attributable to dividend payments and nominal earnings growth (including inflation and real earnings growth).
This suggests that the underlying share prices would have to fall significantly for the capital guarantee on a tracker bond to be worth anything at all. The loss of dividends is a very expensive price to pay for a capital guarantee.
Example Tracker Bond
I'm not picking this product out in particular, it just happens to be the one that I have in front of me right now and illustrates some of the pitfalls of investing in Tracker bonds. These pitfalls apply generally to all Tracker Bond products to a greater or lesser extent.
The disclosed charge in the brochure is 7.53% of the amount invested. This translates to an illustrated reduction in yield of 2.1%pa
However, the same page clearly points out that this is "a capital growth investment and will not benefit from any dividends"
Let's have a look at how much that might matter shall we by looking at the possible income yields on some of the underlying holdings:
I Box Euro Index - Yield 4.29% (source IBOXX Liquid Sovereigns Global 31st March 2008)
Eurostoxx 50 - Yield 3.5% (source Barclays 7/8/08)
EPRA European Property Index - Yield 3.62% (source Barclays 7/8/08)
So, you might be giving up around 3 to 4% each year in lost income on some of the holdings in the product. This is in addition to the charges! For the sake of balance, I should point out that there is no income on some of the underlying holdings (for example 25% invested is in commodities) and so overall you might expect to lose around 2 to 3% in income each year.
So in this example, I am down by around 4 to 5%pa in explicit charges and the implicit cost of lost income. Ouch!
Of course for all these charges, you have the peace of mind of a capital guarantee. 100% of your money will be returned on maturity or as the brochure points out, a guaranteed return of 0%pa CAR!
Let's assume you could obtain a net of Dirt return of 4%pa on your savings over the term of the investment, you have what is known as an "opportunity cost" of cracking on for 16% which is the interest you would have received if you had just left the money in the bank in the first place.
However, the guarantee is only there to stop you losing money. You are investing to profit from the markets right?
In this example, if the underlying investments appreciate, you will receive a cash bonus of 70% of the increase. So, for every 1% of capital appreciation on the underlying holdings, as an investor, you will in fact only receive 0.7%. Or put another way, a 30% "fee" is taken from your profits.
As I say, I'm not knocking this particular product it is simply a useful illustration of some of the issues, I'm sure there are worse examples out there........
Conclusion
They say there are two emotions that move the markets. One is fear; the other, greed. At the beginning of the cycle when the market expands, investors swing from fear to optimism to excitement to out-and-out greed. As the market peaks and contracts, investors shift from greed back to fear. Left unchecked, greed and fear can cloud rational, reasoned investment analysis and distort financial judgement.
This can leave us exposed to the risk of purchasing an investment which on the face of it meets our need for capital security, but which in reality is a relatively poor investment choice. For investors who are prepared to put in a little more effort, there are better ways of managing our conflicting desires for capital security and the best possible investment return than a standard off the shelf packaged product.
"The investor‘s chief problem - and even his worst enemy ' is likely to be himself"
Benjamin Graham, legendary American investor, scholar, teacher and co-author of the 1934 classic, Security Analysis
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