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Last modified: 04/03/08

Capital Protected High Yield Low Volatility Investments

"The sort of investment I'd like is high yield, low risk, and completely liquid".

Yes, I say, as an adviser. I'd like that too. Everyone would like that.

In a perfect world… But, in this world, that's not how it works at all. The higher the yield you want, the more risk you have to take. Which means, the more chance you have of losing money. And perhaps the only way of moderating this equation is to lock up your money for a longish time. So, no liquidity.

But, wait a minute… how about something that has a record of around 20% per year, guarantees you all your money back after five or six years no matter what happens, and allows you to get out whenever you want. Does this come close to a perfect world?

Well, reasonably close. High yield: probably, but not certainly. Low risk: absolutely. Completely liquid: nearly.

It's a new kind of investment, so new it doesn't have an agreed generic name as yet. And 'Capital Protected High Yield Low Volatility Investments' hardly lends itself to a memorable acronym. "I think I'll open a CPHYLVI" doesn't really have a ring about it. But then you can't have everything. So I'll just call them Capital Protected High Yield Low Volatility Investments throughout.

How do they work? Well, let's say you have a sum of $25,000+ - OK, it's not a perfect world: that's what you need to start - and you want it to grow over the medium term.

You invest it in a Capital Protected High Yield Low Volatility Investment. Quite a lot of this money they will put into something absolutely secure, that will grow to your original amount after the agreed investment period. This amount is guaranteed by a major bank with at least two AAs in their risk rating. Banks like Bank of America, Zurich Financial Services, Societe General, the Royal Bank of Canada. If the investment bombs badly, you will get all your principal back at the end of the investment term, guaranteed. The chances of a bank like that failing in the interim? About the same as Western civilisation being annihilated by an asteroid, a new version of bubonic plague or nuclear winter.

Anyway, that's the capital guaranteed part. You get the return of your principal. Now, what about the return on your principal? How does that work?

Well, the company that runs the Capital Protected High Yield Low Volatility Investment does not directly manage your money itself. It selects a number of hedge funds and managed futures houses and…

Wait, wait, wait you say. Hedge funds, managed futures houses: Long Term Capital Management, Tiger, Manhatten. Aren't they dangerous?

Yes, they can be, when they don't tell anyone what they're doing. But the only hedge funds and managed futures houses that will be selected by a Capital Protected High Yield Low Volatility Investment company are those that state their trading discipline and allow the company to run their track record through their risk control system.

In other words they will only deal with hedge funds and managed futures houses that are not loose cannons. They choose a number of these, typically at least four and less than ten, and give them each a percentage of their pooled investment sum, a bit of your money included (you can't get into any of these funds yourself for less than $1m), which the hedge fund or managed futures house invests according to their stated trading rules.

How does this help? Well, three ways. Firstly, if a fund forgets about its trading rules or simply performs badly, the Capital Protected High Yield Low Volatility Investment company can dismiss them, re-adjusting the weightings of the other funds, or straight replace them. Secondly, each particular hedge fund or managed futures house is a specialist in a particular kind of trading or a particular sector (more on this later). Between them, they cover a wide range, but without diluting expertise. Thirdly, because they are all doing different things, their monthly performance does not correlate strongly with each other. Which means the volatility of the overall performance is low.

Low volatility is good. It equates with low risk. In investing, a gentle, undulating hill walk is better than shimmying up and abseiling down saw-toothed peaks.

A measure of the quality of return is the Sharpe ratio. Divide: (the return minus the return you would have got in the risk-free interest of a T-bill) by (the standard deviation of the volatility). World stocks are currently about 0.9. World bonds are currently about 0.7. Capital Protected High Yield Low Volatility Investments typically have a Sharpe ratio in the area of 1.5 ~ 2.9. Which means more return for less risk.

How much return? Actually Capital Protected High Yield Low Volatility Investments are closed-end funds. The guarantor has to know how much they're guaranteeing. The Capital Protected High Yield Low Volatility Investment has a subscription period, which closes. From then on, no-one else can join. The thing continues for its stated period, normally five or six years. Then at the end it pays out the initial capital plus accumulated gains.

Each Capital Protected High Yield Low Volatility Investment is therefore a one-off. Eight or nine of them come along a year. But they don't have a track record until they've actually started. Which means you can't ask what the performance is with a view to getting in. Once they have a performance, you can't get in.

What you can do, however, is look at the pro-forma backtesting. Each of the hedge funds or managed futures has its own track record. The way they trade is the way they trade: it is not altered by their being part of a Capital Protected High Yield Low Volatility Investment. Therefore it is perfectly valid to look at the prior performance of the hedge funds and managed futures chosen by a Capital Protected High Yield Low Volatility Investment in their particular percentage combination and see how they have done collectively in the past. And typically these are in the area of 20%. One I am looking at at the moment shows: 1997 - 17.38%; 1998 - 15.48%; 1999 - 28.53%; year to date - 21.6%. I have taken this one at random, and it's average. Some are over 30% per annum. Personally, I wouldn't mind if one I have only did 12%; I know my money would double in six years.

And these are consistent returns with very few down months, and where there are down months, with much smaller declines than the NASDAQ this April, or the S&P 500 August and October 1998 etc, etc. You get the performance without the grief.

What about the trading? Well, people have been getting used since 1995 to stockmarket returns of 20% a year, and mutual funds that go up and up. This, however, is a very rare phenomenon, unparalleled since, well… 1924 ~ 1929. The stockmarkets won't go up forever, even if we'd like them to. The alternative to stocks is bonds or cash. But bond prices can go down too, and cash performs about as spectacularly as a guinea-pig. If you buy stocks, you are long the market. Performance is defined in upwardness; if stocks go up, you gain, but if they go down, you lose money. Mutual funds are long, geared to markets going up. In fact, they are not allowed to go to cash (except a few percent). In a real bear market, they are waiting to be slaughtered - all they can do is choose the stocks that will perform least badly.

Hedge funds, on the other hand, are allowed to be short the market if that's what they feel is warranted. This means they can sell stocks or stock indexes short and gain as markets fall. Participating in a hedge fund gives you insurance in the time of the bear.

Normally, however, they are not making one-way bets. They are doing things like using their expertise to exploit mergers and takeovers, or finding distressed companies that will see better times. Or, they are finding pairs of companies that do exactly the same thing in the same country, working out which is the better bet, buying shares in it and selling short an equal value of shares in the other company - this way it doesn't matter whether the market goes up, or whether the market goes down, as long as the preferred company outperforms the dispreferred one. There are in fact many, many strategies; the point is that they are more sophisticated than being straight long the market, and enacted by specialists. And it's not just stocks: managed futures houses work in commodities, metals, energy and currencies.

What you are doing by going into a Capital Protected High Yield Low Volatility Investment is buying a basket of such funds for a fixed period. It's a way of investing that is suitable for any set of conditions in the market, an all-terrain vehicle rather than a temperamental sports car that needs a clear track.

Liquidity and charges? There are low front end charges, typically 2 ~ 3%. Performance above is expressed net of management fees. There may be a one year period of lock-in, or no lock-in. There is a decreasing back-end fee, maximum 4% in the first year, if you get out early. For most, after the first year you can get out free, or for 1 ~ 2%. When you get out, you will get your capital plus the gain in the fund if there has been a gain. If there's a loss, the full capital guarantee is only extended at the end of the agreed term. But then, how many investments apart from guinea pigs and T-bills have a guarantee written under them?

Capital Protected High Yield Low Volatility Investments, as I said, are one-offs. Once they're closed, they're closed, so there's little point naming particular ones. Each deserves careful scrutiny (some are better than others). A good financial adviser will be able to let you know his or her current recommendations.