Capital-Protected Products

May require investing loans!



Investing loans are commonly required to be used with capital-protected products such as capital protected funds.

These products provide a safe investing exposure to equity markets with in-built cover if the markets turn sour.

Capital-protected products may be particularly useful in markets such as emerging markets that are likely to be volatile.

Lenders have lists of approved stocks and funds that investors can buy into with their loans.


Characteristics of Capital Protected Products

The common characteristics of this type of investment are ...

  • They guarantee your money back - minus fees or loan interest
  • Most allow you to borrow up to 100 per cent of the investment using investment loans, and some insist on it
  • You have to keep your money invested for a minimum period for the protection to apply
  • When you borrow to invest, the interest is generally tax deductible
  • Some products are harder to exit from than others

Advantages

The comfort of knowing that the product is protected, with the downside covered and exposure to the upside, is appealing when markets are going through a volatile period.

An appeal of the capital protection is that it allows investors to consider diverse asset classes that they may not have thought about otherwise, or that they might not have been previously comfortable with.

Part of the reason for the phenomenal growth in these products is the tax offsets the products offer when 100 per cent of the investment may be a loan.

While the tax offset may be an add-on benefit, the value of the investment should be the primary consideration.


Disadvantages

Recent company failures associated with the global economic recession has highlighted a little known risk associated with capital protected funds.

TAKE CARE! IF THE ISSUER OF THE PRODUCT GOES BELLY UP, YOUR CAPITAL MAY NOT BE AS PROTECTED AS YOU THINK.

Also, if the product requires a long-term investing approach of five or more years, one may question the need for the protection, as time tends to erode investment risk.

Tax benefits aside, I would question whether these products represent good long term financial investments when the additional premium to be paid for the capital protection significantly dilutes any returns that may accrue.


To Conclude

I would judge that the best time to use these products may be when there is market uncertainty and greater potential of volatility ahead, rather than after markets have experienced a large fall.

But having said that, I have difficulty in reconciling an in-built contradiction with capital protected products. On the one hand, they would seem to appeal to investors who are somewhat risk averse.


Yet on the other hand the investors are required to take on investment loans (with associated risk) in order to purchase the product.

Perhaps the taxation benefits have a higher priority with these investing loans than the product being invested in.

If this is the case, then capital protected funds are a turn off for investors using a value investing approach like me. My focus is on the investment.

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