A new equity fund that offers protection for both your capital and your returns could attract more risk-averse investors to equities.
A recently established asset management company has launched a new absolute return equity unit trust fund that it expects will revolutionise the unit trust and retirement industries, allowing investors who can't afford to take risks to invest to a much greater extent in the equity market.
Contego Investment Services has launched a new fund that operates like a floor fund, protecting your capital and locking in positive returns as they are made. ("Contego" means to protect or shield in Latin.)
However, the company claims that the new Contego B5 Protected Equity Fund is one step ahead of floor funds, because floor funds limit the positive returns you can earn when markets rise.
There will be no limit on the returns that you can earn in the B5 Protected Equity Fund, Kobus Louw, a fund manager at Contego, says.
Louw says in the past, equity markets have often risen by 15 to 20 percent in a year, only to retrace the gains and finally end up right where they started or even in negative territory.
"The B5 is designed to lock in returns as they are achieved and this allows the investor to retain gains even if the market ends up in negative territory for the year," he says.
Louw says the fund is constantly protected by means of derivatives - South African Futures Exchange (Safex) options - with the initial floor equal to the amount you invest. This floor rises every time returns are locked in. So, for example, if you invest R100, the initial floor is R100. Derivatives are bought to protect this initial investment, in case the market moves down. But if, instead, the market and your investment rise to R110, a new floor could be set at R110.
Although the protection of your capital through derivatives is not a guarantee, Louw says the likelihood that you could lose any part of your capital after you have been in the B5 Protected Equity Fund for 12 months or more is "very remote".
The B5 Protected Equity Fund was launched on Metropolitan's Odyssey platform in September last year. It was launched as a unitised portfolio available to policyholders. The fund became a unit trust under the Collective Investment Schemes Act and was opened to retail investors in May this year.
There is currently only one other floor fund available as a unit trust fund, the Old Mutual Dynamic Floor Fund. Like the Contego B5 Protected Equity Fund, the Old Mutual Dynamic Floor Fund is classified as a Targeted Absolute and Real Return fund in the unit trust tables. Targeted absolute and real return funds are those that target a positive return regardless of the direction of the market.
However, while both the Contego B5 Protected Equity Fund and the Old Mutual Dynamic Floor Fund are regarded as absolute return funds and as floor funds, there are important differences between them.
The Old Mutual Dynamic Floor Fund is a flexible asset allocation fund that invests across equities, bonds, property and cash, while the Contego fund invests only in equities and their derivatives.
The Old Mutual Dynamic Floor Fund has to rely on the skill of its manager to sell equities or futures when the market is high. But, while selling futures locks in performance, it also caps the upside performance, as a futures contract binds you to buying or selling a security at a fixed price, Louw says.
Also, very few managers have been able to time the market consistently.
The B5 Protected Equity Fund, on the other hand, makes use of Safex put options for protection and to lock in returns. This does not cap the upside potential and it does not require a strong view on the market, because the fund manager has the discretion to sell the underlying security if markets decline. But if market conditions are positive, the manager is not obliged to exercise the option.
The fund is thus protected if markets decline, but will rise if markets are positive.
Louw says put options will be used to set the floor whenever Contego believes it is necessary to do so. A battery of factors will be considered when resetting the floor, he says. However, the options, Louw says, will only be used for protection. There won't be any gearing or borrowing to invest, which would make the investment more risky.
The benchmark for the B5 Protected Equity fund is the JSE/FTSE Top 40 (capital) index.
The fund will invest in shares that are selected on a fundamental as well as a quantitative basis, and will be actively managed with a focus on stock selection.
The aim of this portfolio is to out-perform the Top 40 index by five percent a year at a low risk. This, Louw says, will be ensured by maintaining a tracking error to the Top 40 index of no more than five percent.
Louw says Contego prefers value shares that offer high dividend yields, because these shares stabilise the performance of the fund over time and the dividends can be used to offset the cost of the put options.
The cost of buying the put options that will be used to protect the floor of the fund should be more than covered by the expected out-performance of the shares in the portfolio and the above-average dividend yields these shares will earn, Louw says.
Performance
The Contego B5 Protected Equity Fund only had a nine-month track record by the end of May this year (usually considered too short a period to judge performance), but over that period had out-performed its benchmark by 2.7 percent, returning 19.2 percent compared with the 16.5 percent from the Top 40 index.
The fund also proved itself in April this year, Louw says, when the equity market slumped by more than eight percent. The B5 Protected Equity Fund maintained its floor value just below 15 percent.
He says the fund's performance has been measured according to collective investment scheme requirements, although the fund only became a collective investment in May this year. Contego also manages a general equity fund, the Contego TT Equity Fund. It has a two-and-a-half-year track record and has out-performed the benchmark Top40 index consistently by 10 percent a year over this period. Louw says the performance of this fund shows Contego's skill for actively managing an equity fund.
The B5 fund combines this skill with the dynamic protection of your capital and returns.
Louw says he has been testing and refining the technique used in the B5 Protected Equity Fund for more than three years. Previously, Louw was with Cadiz, where he managed a fund similar to the B5 Protected Equity fund.
Who should invest
Louw says the B5 Protected Equity Fund is suitable for all kinds of investors, from conservative to aggressive. However, it is ideal for investors who want unlimited equity exposure, but are concerned about the risks and want their capital preserved. There are many investors, Louw says, who would like to invest in equities. More mature investors would like to invest in equities because they need to hedge their finances against the ravages of inflation and spiralling medical costs. Unfortunately, most of these people cannot tolerate the high volatility of returns that is typical of equities, because they do not have the luxury of waiting for stock markets to recover because they live off their investment income, he says.
The B5 Protected Equity Fund opens a whole new world to them, he says, as it offers them upside potential of equity, but with capital protection and a lock-in of the returns the fund earns. Louw says Contego believes that this type of fund could cause a revolution in the retirement industry, as it makes a mockery of the so-called life-phase member choices offered by most retirement funds. In terms of life-phase choices, most retirement funds offer young members up to 75 percent equity exposure, while restricting older members (age 50+) to an equity exposure of between 35 and 40 percent. Louw says with the B5 Protected Equity Fund, retirement funds will be able to offer mature members the option to invest up to 75 percent of their savings in equities, because the fund offers protection of both capital and returns.
The fund will also make life much easier for financial advisers, who in terms of the Financial Advisory and Intermediary Services Act have to give you best advice, which includes making a call on the timing of your investments into the equity market. They will no longer have to worry about timing, because the fund performs in line with equity markets when they rise, but automatically protects fund values when markets decline, he says.
Costs and minimum investments
The initial charges vary, depending whether the transaction is concluded through Metropolitan or a linked investment service provider (Lisp). If the investor invests through Metropolitan, Metropolitan takes 0.25 percent, the broker between zero and three percent and Contego (as the manager) between zero and 0.5 percent. (All these fees exclude VAT.)
If the transaction takes place through a Lisp, Metropolitan charges 0.25 percent and no further initial charges apply.
The annual management fee is 1.25 percent. A performance fee of 20 percent of the out-performance of the benchmark (Top 40 Index) is levied monthly in arrears on delivery of positive returns. A high watermark rule - or maximum fee - applies. This means that if the fund performs below its benchmark, a performance fee will not be applied until the fund catches up the earlier under-performance.
The minimum lump-sum investment is R5 000 and the minimum monthly investment is R500. Dividends can be reinvested.
Definitions
Futures:
A futures contract is a binding agreement to trade a specified quantity of a particular item or asset on a fixed date in the future at an agreed price. The asset could be a share, an agricultural product, such as maize, a currency, or a basket of shares that make up an index.
Put options:
Options give an investor the right, but not the obligation, to sell a specified quantity of an asset at an agreed price, on a fixed date. In other words, put options differ from futures in that the investor does not have to carry out the transaction or "exercise the option". Because of this they can be used in a way that does not cap the upside performance (meaning it does not limit the positive returns you can earn) of an investment.
High dividend yields:
The dividend yield of a share is the amount a share pays out in dividends expressed as a percentage of the share price. It is essentially the return you earn on your investment from dividends, without taking into account the capital growth in that share that is a result of the appreciation of its price. Shares paying high dividend yields generally have low share prices and high dividends.
This article was first published in Personal Finance magazine, 3rd Quarter 2005. See what's in our latest issue