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Imagine if you could invest in the stock market with a guarantee that if it drops by up to 40% by the end of six years, you’ll still get your money back. In this age of uncertainty, that is a nice underpinning for returns on any portfolio, but where’s the catch?

What are Defined Returns strategies?

A Defined Returns fund seeks to deliver a pre-determined rate of return over a specific period of time, dependent on broad market performance. This makes it more predictable and offers an element of downside protection, distinguishing it from other investment strategies.

What makes them less risky?

Money-back protection is provided by the investments known as ‘autocalls’, which are part of a wider group of investments called structured products. This corner of the market isn’t often shouted about, despite being more than double the size of all hedge funds at $7 trillion.

Autocalls effectively pay a fixed rate of income each year depending on the level of the stock market. Say that you bought a six-year autocall from Goldman Sachs that pays 10% per annum, when the FTSE Index is at 7,500. After one year, if the FTSE 100 Index is above the original 7,500 level, the product will mature, and you would receive the original investment plus 10%. Alternatively, if the Index is below 7,500, then you would wait another year for the next review.

The following year, on the same date as you bought the autocall, and reviewed it previously, the same process applies. If the market is above 7,500, you would receive the original investment plus 20% or if the market isn’t above 7,500, it would be reviewed again in 12 months.

This process would continue for six years (because you’d taken out a six-year autocall) and on the last day of the autocall, one of three things could happen. If the FTSE Index is above 7,500, then you would receive the original investment, plus 60%, because it’s 6 years at 10%pa. If the Index is below 7,500, then you would get your original investment back with no extra return. Or if the market has fallen by more than 40%, you would only receive the value minus the percentage fall of the original investment. In other words, if you invested £100 and market had fallen 80%, you would receive £20 back.

The limitations of Defined Returns

One limitation of Defined Returns is hinted at in the name itself: the returns are defined, meaning that they’re fixed. If you think that the stock market is going up by more than the autocall is set to pay per annum, for example 10% as it was in the above example, then your money may be better invested in an index tracker fund.

Additionally, Defined Returns funds may be more expensive to invest in originally because of their more predictable nature. However, for the increased cost, investors gain more assurance of what they will receive back, in contrast to most funds, where this level of prediction is not possible, and returns are not defined.

Another consideration to make is that the FTSE 100 Index pays a dividend yield of 3.5%, which you would not receive through the autocall. This is because their value and return are determined by the capital-only level of the FTSE 100 Index. To put this in perspective, over six years, this could amount to over 20% which could be gained on an index tracker fund but not in an autocall.

Benefits of Defined Returns

Defined Returns Funds are a good addition to an investment portfolio, helping to balance it out with potentially more volatile funds as they are more predictable and offer enhanced protection. As returns from equities in coming years are set to decrease, they may further grow in popularity, earning a place in many investors’ portfolios.

When is the best time to invest?

If market returns are low, autocalls are a particularly attractive option. This is because the stock market only has to go up by a small amount to receive good returns. As a result, if you invest in these products at a good time, then good returns are still achievable, even when the market is sluggish. At other times, you can get still get similar returns to the market, but with the added reassurance of capital protection.

This feature is intended as an informative piece and does not construe advice. If you have any further questions, please don’t hesitate to get in touch with us.

Established in 1995, Equilibrium is an award-winning Chartered wealth management company with a tailored and personal approach to financial planning services including investment management, IHT planning and retirement planning. Its purpose is to make people’s lives better by helping them to live the life they want; look after those they love and leave a powerful legacy. 

Please note this article does not constitute investment advice. Investors are encouraged to do their own research beforehand or consult a professional advisor.

Stuart Fieldhouse

Stuart Fieldhouse

Stuart Fieldhouse has spent 25 years in journalism and marketing, including as a wealth management editor for the Financial Times group, covering capital markets and international private banking, and as an investment banking correspondent for Euromoney in Hong Kong. He was the founder editor of The Hedge Fund Journal.

Stuart has worked at CMC Markets, supporting the re-launch of its global financial spread betting and CFD trading platforms. He is also the author of two books on trading, published by Financial Times Pearson. Based in The Armchair Trader’s London office, Stuart continues to advise fund managers, private banks, family offices and other financial institutions.

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