Wasiliev | Flexible product comes with high risk

John Wasiliev

Colin Lewis says investors should understand risk. Photo: Tamara Voninski

An attraction of having a do-it-yourself super fund is the scope to personally manage the fund’s investments. An underlying principle of DIY super is that fund trustees can make investment decisions as they see fit.

While this suggests considerable flexibility on the investment front, there are also limitations, guidelines and responsibilities associated with DIY fund investing. These various issues are meant to prompt and encourage trustees to investigate and thoroughly understand potential investments before acting.

Like the reader who asks about an alternative investment being offered by the Commonwealth Bank of Australia. It’s a financial product described as Commonwealth Bank Vantage+ which the bank is promoting as a suitable investment for DIY funds among other investors.

The reader’s question is: is the product, which promotes medium- to long-term (three to five years) leveraged exposure to the stock exchange’s S&P/ASX 200 Index a derivative investment that requires the fund to prepare a risk management statement? But of greater significance is the reader’s appreciation of the product as an investment.

The product, says managed investments analyst Rodney Lay, director of fund services at S&P Capital IQ, is a structured investment developed by the Commonwealth Bank that allows an investor to leverage on the possibility of a strong rally in the Australian stockmarket in the next three or five years.

For an outlay of one-fifth or one-sixth of the investment’s underlying value, an investor can get the same result as if they bought the investment outright, so long as the market delivers a desired performance.

While the product has derivative elements to it, the actual structure is a deferred purchase agreement which means it has no derivative- related restrictions. The reason why the product is structured this way, says Lay, is so it can be offered to investors either directly or via an adviser who is not required to be a derivatives specialist.

As far as the derivative elements are concerned, the product is based on a call option structure. Essentially, the investor buys an at-the-money call option over the S&P/ASX 200 Index with either a three-year or five-year expiry date, depending on the strategy. Call options have inbuilt leverage that allows an investor to speculate that the underlying investment will rise.

The underlying investment in the Vantage product is the SPDR S&P/ASX 200 exchange traded fund.

Rather than buying an outright position in the ETF, taking a call option-based position allows a particular view to be taken at a lower up-front cost.

According to Lay, the necessary view for an investor in the Vantage product is a solid outlook for Australian shares during the period of the investment. If this view is confirmed by market action, the investment should perform as expected. Overall, S&P describes Vantage as a solid product that should deliver if the market performs.

Alternatively, if the market doesn’t perform, investors should be prepared to incur a significant loss on the capital they invest.

The product is considered to be high risk, with the prospect of a total loss of invested capital a possibility. This means investors should consider their tolerance of a loss and the percentage of their overall investment portfolio they wish to commit.

The target audience is investors who are underweight equities and who are looking to increase their exposure to Australian shares. The idea of the strategy is that an investor might commit 2 per cent of their portfolio and through leverage have a 10 per cent market exposure. Like all structured products the investment has its risks.

S&P’s analysis says issuers of similar leveraged products have suggested that only a very small percentage of a total portfolio be allocated to such products. It agrees with this view given the risk-return profile of the product.

Because the asset value is based on a derivative structure, the performance of the investment is not a straight line. This needs to be factored in by anyone who might think they can exit before the three-or five-year maturity. While it is possible to exit early and the promoter will value the investment at regular intervals, it’ll be a discounted return. In addition there is a $500 early termination fee.

During the term of the investment, it pays no income and any profitable return will come in the form of a capital gain.

Colin Lewis of ipac Investment Services says with any structured product it is essential investors know what they are getting into.

DIY fund investors should not blindly go into investments and then complain when they suffer losses. They should understand what it means from a risk perspective when investors are offered the opportunity to double their returns.

The Australian Financial Review