Well let’s start with what it’s not. It is not a long-only equity fund. It is not a long/short equity fund. It is not a hedge fund. It is not a fund which seeks to beat a particular benchmark or index.
Rather, a defined returns fund is a fund which seeks to deliver a pre-determined rate of return over a specified period of time. For example, a fund might seek to deliver 5-7% per annum over rolling five-year periods. You might well ask is this not what an equity fund might do. Well, yes and no. An equity fund may have an expected return of 5-7% but achieving such will be hugely dependant on what equity markets as a whole do over the period in question. This is particularly true if the fund is a passive or indexed fund as it will merely track the market. A defined returns fund, however, will seek to deliver its defined return regardless of broad market performance, which distinguishes it from many other investment strategies.
Let’s talk predictability.
Predictability is hard to come by when investing. It is this elusive characteristic that also distinguishes defined returns funds from most others. That is to say, the defined return is much more predictable than the expected return one might have with say a long-only equity fund. The return on the underlying asset in an equity fund is inherently unpredictable. The underlying asset in a defined returns fund is considerably more predictable. In fact, one might say that the return is contractually bound. The assets which a defined returns fund invests in have, you guessed it, defined returns. As an example, the defined return asset (a structured note) within the fund might have a payoff along the following lines: If after one year a particular index or basket of stocks is above, say, 90% of its starting value (does not fall by more than 10%), then a return of 7% is paid. Let’s say you are also invested in a passive long-only equity fund with an expected return of say 7%. In the case of the latter, for the 7% to be delivered the underlying market or index has to go up by 7%. What is the more likely scenario? That the market goes up by 7% (or more) or does not fall by more than 10%. Clearly the latter is more likely. Therefore, that return in the defined return setting is more predictable.
In addition, defined returns funds, those investing in structured notes, will have capital protection built in. So, for example, the underlying notes within the fund will usually have, say, a 60% capital protection barrier. To further explain: The underlying index or shares might be down 39% at the end of the term but the note would then mature at 100% – no loss, in other words. Having said that the gain would be zero in that scenario too. But surely that’s better than a 39% loss?! If at the end of the term of that note – five years usually – the particular underlying stocks or index on which it is based are below 60% the original value then a loss will incur. But that loss is no worse than the loss that would have occurred had one owned the underlying itself. A diversified portfolio of these types of defined return notes equals a defined returns fund.
Pros and cons
Like any investment or asset class there are pros and cons:
- Equity-like returns;
- Less volatility/risky than equities;
- More predictable returns.
- Defined returns funds may be more expensive than a long-only equity fund;
- Upside is forgone in very strong bull markets;
- Requires a little more explanation.
So, what role could these funds play in a portfolio?
In an environment where returns from equities over the next ten years are projected to be less than half of what they were over the previous decades, then they may very well have a crucial role to play. Defined returns funds tend to be less volatile than equity funds, their correlation to equities is usually less than one and their risk rating (ESMA) tends to be one to two notches below equity funds. Given defined returns funds contractually lock in the underling returns subject to certain conditions they can act as an equity replacement in a portfolio. However, more likely, is that it complements an existing equity allocation and serves to dampen the overall volatility of the returns without sacrificing the quantum of those returns.
In a world where building a well-balanced portfolio to deliver on clients’ expectations is increasingly difficult, defined returns funds have a role to play.
Author: Peter Murphy, Managing Director, Insignia Financial Ltd. To find out more go to www.insigniafinancial.ie