Kick Out plans were the real story of 2011, with a huge surge of interest that continues to keep pace. With such a wide variety of products available in the market, we take an in-depth look under the bonnet of these plans to find out why they are growing so much in popularity and what they offer to investors.
What is a Kick Out plan?
The autocall investment, or Kick Out plan as it is more commonly known, is a market-linked investment which can automatically mature or ‘kick out’ returning the original capital and the stated returns. The early maturity is dependent on pre-determined market conditions being achieved (typically a pre-determined barrier on a set observation date) and most plans offer the potential to mature early each year.
Therefore, the investor has the benefit of knowing at outset the conditions that need to be met in order to produce the stated returns, thus providing a defined return for a defined amount of risk. The plans that follow an index are considered lower risk than those that follow a basket of shares, however the latter type of plan normally offers the higher returns.
Simple to understand
In combination with an investment term normally in the region of 5 to 6 years, the mechanics just outlined create a plan which is relatively easy to understand, with the early maturity normally dependent on the underlying investment finishing higher at the end of each year than its starting value. This pre-defined risk v reward is an attractive feature for many investors.
When reviewing all of the plans available in the market, Fair Investment pays particular attention to the underlying asset which the plan is linked to. Nearly all of the plans we list are linked to the FTSE 100 (FTSE) on the basis that this index is widely recognised as the proxy benchmark for most investment managers and the historical volatility is familiar to many investors.
Popular in all markets?
Traditionally, these plans have proved popular when the FTSE has been at historically low levels, on the basis that the investor considers it more likely that the index will be higher on at least one of the plan’s anniversaries. Should the investor miss out in years 1 or 2 for example, they still have a number of years remaining and the level of potential return keeps increasing year on year.
However, these plans have also generated particular interest when markets are at historically high levels. The reason for this is that for many plans to mature early, the level of the FTSE at the end of the year only has to be higher than its starting value. This means that even if the FTSE has only gone up by 0.1%, you would receive the full growth return, with many plans currently offering double digit annual returns. When this happens your return is far greater than the market, which is obviously very attractive to investors.
What does ‘capital at risk’ actually mean?
In order to have the potential for returns which are currently far higher than those available from cash, the investor’s capital is put at risk. Your original capital is returned if the plan kicks out but in the event of the plan not kicking out, capital will typically be returned provided the FTSE has not fallen below 50% of the starting level of the index.
One feature to check is whether this 50% barrier is tested throughout the investment term or only at the end since the former is more likely to occur than the latter. To put both methods into context, based on yesterday’s closing value for the FTSE of 5892.2, the index would have to fall to 2,946.1 before your capital would be at risk. Since this is a level not seen since the end of 1994, many investors consider this to be a competitive trade off for the potential returns available although we must remember that past performance of the underlying index is not a guide to future performance.
Further, in addition to the more familiar conditional protection described above, we have recently seen a rapid increase in the use of this type of product combined with full capital protection. Aside from this difference, these plans work in exactly the same way but offer the potential for returns which are higher than those currently available from the more traditional fixed rate bond.
With the continued pressure on interest rates forcing savers to consider alternative options, the capital protection offered by these structured deposits has greatly broadened the appeal of this type of product and these plans are also covered by the Financial Services Compensation Scheme.
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One feature that is important for investors to understand is counterparty risk, which is the likelihood that a particular institution will be unable to repay any money owed. This could therefore potentially have an impact on your returns which is separate to the performance of the underlying index.
There are a number of credit ratings available provided by leading credit rating agencies such as Standard & Poor’s, Fitch and Moody’s and although these are only one way to assess the counterparty to each individual plan, they do provide a useful starting point. In addition, a recent development has seen some plans offer the option to spread this risk by using a number of counterparties, although the potential returns will be slightly lower.
Liquidity can be an important part of investing since none of us know what lies around the corner and we may need to draw on our investments earlier than planned. Unlike investment funds, daily liquidity is not normally available and the secondary market is still developing so this is an important consideration.
Kick Out plans are certainly designed to be held for the full term, however most investments should be made on the basis of you not requiring the capital for at least 5 years and as such are the same as any other investment. In the event of requiring the funds before the investment matures, a value can always be obtained from the plan provider and proceeds are normally available quickly. This value will reflect any early exit charges as well the market value of the holdings so could be higher or lower than your original investment.
With Kick Out plans all of the charges are taken into account in the headline return so there are no hidden surprises. A typical fund, on the other hand, will often have an initial charge (up to 5.5%), and figures from research group Morningstar have revealed that the total annual charges for an active UK equity fund is 1.66%, meaning the fund has to outperform the index by this amount each and every year just to stay level.
The costs associated with the ongoing management of funds provides an immediate return hurdle, whether actively managed or a tracker fund, and this is even more pronounced when markets fall. This is evidenced by the large number of funds which fail to outperform the FTSE each year and especially over a five year period, making the Kick Out a cost-effective option by comparison.
Using you ISA allowance
Finally, all of the Kick Out plans detailed by us on fairinvestment.co.uk are available for individuals to use their annual stocks and shares ISA allowance and will also accept investment ISA transfers. For the current tax year the annual allowance is £10,680 which will be increasing by £600 to £11,280 from 6th April 2012.
The way forward....?
The above summary highlights the pros and cons of the Kick Out plan for those looking for higher returns and who are prepared to put their capital at risk. The reality is that many funds do fail to outperform their benchmark and overall, these plans offer an attractive risk v reward when compared with other investments that offer exposure to the FTSE.
With the additional feature of capital protection that some plans provide, Kick Out plans are a competitive option for many investors, and the current range available in the market is also offering some of the highest rates ever from this type of investment. This certainly helps to explain why Kick Outs are proving so popular with investors.
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No news, feature, article or comment should be seen as a personal recommendation to invest.
Different types of investment carry different levels of risk and may not be suitable for all investors.
Some structured investment plans are not capital protected and there may be the risk of losing some or all of your initial investment. There is also a risk that the company backing the plan or any company associated with the plan may be unable to repay your initial investment and any returns stated, in which case you may not be entitled to compensation from the Financial Services Compensation Scheme (FSCS). In addition, you may not get back the full amount invested if the plan is not held for the full term. The past performance of the FTSE 100 Index is not a guide to its future performance.
Prior to making any decision to invest, you should ensure that you are familiar with the risks associated with a particular investment. If you are at all unsure of the suitability of a particular investment, both in respect of its objectives and its risk profile, you should seek independent financial advice.
© Fair Investment Company Limited