As a result of the volatile investment climate and with the value of Australian retail and international share funds falling, a risk adverse investment strategy is becoming a vital core component of any balanced portfolio. Increasingly, investors are looking for products that provide exposure to the stock market, yet offer the security of maintaining their initial capital outlays.
Product Evolution
The Australian retail equity derivative market has followed the path of the U.S. and European markets and experienced significant growth in the past three years. This growth was initially driven by the expansion of the listed warrants market and coincided with extensive investor education, broadening the awareness of retail equity derivatives.
In the face of recent equity market volatility and in line with overseas trends, growing investor appetite turned to more defensive investments and resulted in the development of products tailored to meet the current and changing economic climate. To meet these changing investment requirements, the market has evolved to offering several innovative and flexible structures. Such products are capital protected and give investors a low risk opportunity to participate in the upside performance of underlying reference assets such as global stock market indices or baskets of shares.
Example: Capture-The-Peaks
To illustrate the evolution of the Australian retail equity derivatives market it is worthwhile to highlight some recently issued "capture-the-peaks" structures.
Risks
Despite the fact that the example products have capital protection, there are several risks involved in investing in these instruments, as with any financial product.
* Capital protection only applies to investments held for
the full three-year term
* Early maturity or termination prior to the maturity
date could mean investors receive less than their initial
capital invested
* Possibility of no capital appreciation if the
capture-the-peaks strategy results in zero or negative
returns
* Returns may be less than the return on other investments
including term deposits or a direct investment in the Dow
Jones Industrial Average.
Hypothetical Returns
It is illustrative to show how these capture-the-peaks products work under different hypothetical market examples. Consider a gently rising market without a strong and persistent market trend. The table and graph below show the impact of this hypothetical market trend on such a product.
Historical Performance
The graph below shows a historic back test for the example product over both the short and long term. These results indicate significant chances of the maximum return (44.9% using the short term sample and 25.5% using the long term sample) while modest chances of the minimum return (10% of the short term sample and 23.1% for the long term sample).
Summary
In summary, this innovation gives investors four key benefits over traditional retail investment products:
* Growth Potential--The capture-the-peaks product
provides exposure to the growth potential of equity
markets by linking the performance of the investment
to the reference index.
* Capital Protection--The products offer full capital
protection, guaranteeing the return of the initial
investment on the maturity date.
* Diversification--Incorporating these products with
holdings in other equity and money market instruments
provides a degree of diversity.
* Control of Currency Risk--The product and final return
is denominated in Australian Dollars.
This week's Country Focus was written by Thomas Gillespie, head of equity derivatives research, and Michael Walker, head of equity structured products at Citigroup Global Markets Australia.
