Understanding capital terms

Saturday November 7, 2009

By FINTAN NG

There is always an element of risk where investing is concerned. It is just a matter of whether people take the time to read the fine print and understand the risks they are exposed to when they invest.

Most investors in financial products would have come across the terms “capital guaranteed fund” and “capital protected fund”, but whether they understand these terms well is another matter, even if these terms are explained in the prospectus.

Basically, a capital guaranteed fund is a fund where the investor’s principal is fully protected. The fund usually invests most of the money in low-risk instruments such as government bonds, with only a small amount in riskier assets. Consequently, the returns are lower.

In a capital protected fund, the protection may involve a variety of instruments, the performance of which will determine whether investors retain, lose some or all of the principal amount invested.

In many instances, capital protected products have been sold to investors, with the impression – perhaps unintentionally – that they will not lose the principal sum at maturity.

However, the fine print will inform the investor on how the banks or other financial institutions intend to protect the sum invested. In the years before the global financial crisis, this usually involve securities known as options, swaps or collateralised debt obligations (CDOs).

Unfortunately, many investors, including seasoned ones, do not understand the risks involved when such assets are used to securitise their investments.

There are those who cannot even differentiate between capital guaranteed and capital protected.

We now know that CDOs, especially those with asset-backed securities linked to subprime mortgages, were among the chief culprits in the collapse of the US financial system.

The stark reminder of what can happen when people invest their money with only half an understanding of the risks involved, hit closer to home when the financial crisis peaked more than a year ago with the bankruptcy of Lehman Brothers Holdings Inc, which also saw the near collapse of insurer American International Group Inc.

Among those affected were investors in Hong Kong and Singapore, who invested in the Lehman minibonds, which were first issued in 2002. Investors of Singapore-based DBS Group Holdings Ltd’s “high notes” as well as Merrill Lynch & Co’s “jubilee notes” were also affected.

These people invested in what is known as structured deposits or structured notes, which were capital protected not capital guaranteed.

Anecdotal evidence gleaned from news reports from last year show that often these investors do not understand what they were investing in or have been misled into believing that they had invested in risk-free products.

Most of them, whose demonstrations outside the banks were captured on television, saw a significant part of their life’s savings evaporate in the wake of the financial crisis.

One consequence of the massive losses incurred by investors last year was the banning of the term “capital protected” by the Monetary Authority of Singapore (MAS).

In a statement in early September, MAS said the ban on the term would apply to mass-market products familiar to retail investors, including structured notes, unit trusts and investment-linked life insurance policies.

According to Singapore’s Straits Times, financial institutions in Singapore now have to provide customers with simple, user-friendly ‘product highlights sheets’ and providing ‘health warnings’ on complex investments in appropriately large font.

There are those who will also post the question of how sound the financial institution providing the guarantee for capital guaranteed products are, especially since the financial services industry have seen so many banks get in trouble or go bust between July 2007 (when the subprime crisis began) and now.

One way to find out is to look at the credit rating and balance sheet of these guarantors, which are usually public information.

Otherwise, information on the guarantors are also available on the prospectus of the fund.

A website on investment education had this to say about capital guaranteed funds: “When we invest with little or no risk, we pay for it by compromising on potential returns.”