The Investor’s Guide to Kick Out Plans
It seems that regardless of the prevailing economic conditions, the kick out investment continues to be a popular choice with investors. Although not yet a mainstream investment when compared with investment funds, the defined return and defined risk on offer from this fixed term investment seems to make them particularly sought after when the market is at historically high levels and investors are finding it difficult to commit. We take a closer look at the kick out plan to try and understand why their popularity has continued to rise in recent years. We also consider how this might make for an attractive opportunity in the current investment climate as well as review some of the recent market trends.
Kick out investments hitting the mark
The defined return for a defined level of risk has made the structured investment an attractive addition to the range of investment options available, whilst in recent years the kick out plan has been the stand out of this type of investment in terms of popularity. Capable of adapting its structure in line with market conditions and investor demands, the inherent flexibility in how these plans can be put together is perhaps one of the main reasons for their continuing popularity, seemingly hitting the mark with a wide range of investors.
What is a kick out investment?
Kick out investments, or ‘autocalls’ to use the correct investment term, are fixed term investments that pay out a defined return providing a predefined event takes place. This predefined event is linked to the performance of an underlying investment, often a stock market index such as the FTSE 100 or sometimes a small number of FTSE 100 listed shares. If this ‘trigger’ event occurs, the plan automatically matures early or ‘kicks out’, returning your original capital along with the defined returns offered at the outset. Should this event fail to occur, the plan keeps going to subsequent trigger anniversaries or until the end of the fixed term.
When considering which kick out investment might meet your needs, it is important to review and compare the differences between the various plans available. Here are some of the main features to consider.
The headline return on offer is understandably the investor’s initial focus when reviewing an investment. These are defined returns which are paid depending on the performance of the underlying investment. The headline return is normally an annual return expressed as a percentage, which is then multiplied by the number of years invested should the investment mature early or at the end of the term. It is important to note that these returns are not compounded, for example if the headline rate is 9% and the investment kicks out at the end of year 3, the growth return paid will be 27% (plus a return of your original investment).
The level of return on offer should be compared to risk free returns, perhaps those readily available from holding cash for a similar period of time. This will allow the investor to consider whether they are prepared to put their capital at risk in order to achieve the potential upside.
The underlying investment
The underlying investment to which the kick out plan is linked is an important feature since it is the future movements of this which determines whether you receive any returns, and normally determines what happens to your original investment as well.
The majority of kick out plans continue to use the FTSE 100 as the underlying index. This is widely recognised as the proxy benchmark for most investment managers and the historical volatility is familiar to many investors. The ability to review the rise and falls of the FTSE over more than 25 years offers the investor some context as to how high and how frequent the falls and rises have been, always though with the caveat that past performance is not a guide to future performance.
Designed to be held for the full term
Most of the kick out investments currently available are either five or six years in term, with the potential to kick out early normally from the end of year one or two onwards. However, there is no guarantee that the plan will mature early and so they are designed to be held for the full term. Most kick out investments though, will allow you to withdraw your money early if you need to, although this could mean you receive less (or more) than you originally put in, therefore it is important that before you commit, you are able to tie up your capital for the maximum term.
In addition, once the plan starts you will not be able to add any additional capital to the same investment. There may however, be another issue of the plan available at a future date although the terms and headline return on offer may vary.
Your capital is at risk
As with the majority of investments and in line with the principle of risk v reward, in order to have the potential for returns which are higher than those available from cash, the investor’s capital is put at risk. This means there is a possibility that you could lose some or all of your initial investment.
Conditional capital protection
The other feature of kick out plans is the inclusion of what is known as conditional capital protection. This means that should the investment fail to mature early or at the end of the term, your initial capital is returned subject to the performance of the underlying investment. Typically, provided the underlying investment has not fallen below a predetermined level, your initial investment is returned in full. This barrier is commonly 50% of its value at the start of the investment although 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, for a plan based on the performance of the FTSE 100 Index, based on this morning’s opening value of 6, 646.6 the index would have to fall to a closing level of 3, 323.3 before your capital would be at risk, a level not seen since the middle of 1995. Please also remember that past performance is not a guide to future performance.
When can a kick out occur?
The early maturity can occur normally from the first anniversary and then every year thereafter. This is dependent on pre-determined market conditions being achieved, for example, the FTSE being higher than its value at the start of the plan.
However, due to market conditions there are currently a larger number of kick out investments that have pushed back the earliest year they can mature early, mostly from year one to year two. Not only does this have a potential impact on whether the plan provides a return, this should also be considered against the investor’s view of what could happen to the underlying investment in the coming years.
Popular in all markets?
Traditionally, kick out 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, as they are now. The reason 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 Index has only gone up by a small amount you would receive the full growth return, in which case you would have beaten the market.
Kick out market trends
The market volatility over recent years has led to indices largely tracking sideways, neither driving forward nor back for any prolonged period or certainty. The FTSE 100 for example has maintained a level above 6,000 since the start of 2013 and yet has never broken through the 7,000 point barrier in its history. In this environment, investors can often be driven to look for investments that can produce cash-plus returns in a low growth, low interest rate environment.
Kick out investments have certainly delivered in this space, offering high single and double-digit returns, often paying after one to two years of the investment, while at the same time, with a conditional capital protection ‘barrier’, typically set at 50%, protecting the investor’s capital against all but the most extreme market falls.
When markets are at historically high levels it can lead investors to question whether now is the right time to invest, with conflicting expert views on what might happen to the FTSE to be expected. Certainly it is understandable that investors remain nervous about the way the markets have been behaving in 2013 and are therefore open to taking defensive measures within their investment.
In response, the market has seen a noticeable increase in the number of kick out investments being launched with defensive features, which broadly fall into two categories. The first is where the level required each year remains the same but is lower than its starting level. The second is the ‘step down’ kick out plan where the level of the FTSE required for the plan to mature reduces each year.
Shares instead of an Index
Another recent trend has seen the use of a small number of FTSE 100 listed shares as the underlying investment, instead of a stock market index. The number of shares normally varies between three and five with the potential return on offer being greater than those plans based on an index such as the FTSE. Often the value of the shares required in order for the investment to kick out reduces over the term of the plan.
However, as individual share prices can move by a wide margin these plans represent a higher risk investment, especially since any growth as well as the return of your capital is dependent on the worst performing share.
Dual indices, for more experienced investors
Finally, there has also been a trend of basing the kick out on the performance of more than one index, the most popular being to mix the FTSE 100 with either the S&P 500 in the US and the Euro Stoxx 50, an Index designed to reflect the largest blue-chip businesses in the Eurozone, excluding the UK. As indices they should be less risky than investments based on the performance of a small number of shares and yet it is important to understand the correlation between the two indices prior to investing. For this reason we feature them in our experienced investor section.
Full capital protection – the structured deposit
At the other end of the risk spectrum there has also been an increase in the use of this type of product combined with full capital protection, in the shape of a structured deposit. Aside from this difference, these plans work in exactly the same way and the potential returns on offer are higher than those currently available from the more traditional fixed rate bond. However, unlike fixed rate the returns are not guaranteed.
With the continued pressure on interest rates forcing savers to consider alternative options, the capital protection offered by these structured deposits have greatly broadened the appeal of this type of product. As deposits they also bring the peace of mind of Financial Services Compensation Scheme eligibility.
Finally, since your investment is used to purchase securities issued by a counterparty, usually a bank, one feature that is important for investors to understand is counterparty risk – the likelihood that the particular institution in question will be unable to repay any money owed. This could therefore have a potential 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.
Watch out for deadlines
Each issue of a kick out investment plan is normally only available during a specific offer period – usually 6 to 8 weeks long. If you miss the deadline, you will not be able to take out that particular plan. However, most providers will offer a new version of the plan with the same or similar terms soon after. The returns on the new investment may be different from the previous one, depending on how markets have moved in the meantime – so they could be better, the same, or worse.
With both capital at risk and capital protected kick out plans, the investor has the benefit of knowing at outset the conditions that need to be met in order to provide the stated returns. This allows the investor to consider whether the potentially higher returns are worthwhile, compared to the ‘risk free’ returns from cash held for a similar period. With cash returns continuing at their record lows, this has been an easier decision in recent years which perhaps helps to explain why kick out plans have increased in popularity.
No news, feature article or comment should be seen as a personal recommendation to invest. 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. Tax treatment depends on your individual circumstances and may change. Make sure you check whether any charges apply prior to transferring any existing investment.
The capital protected plan referred to in this article is a structured deposit plan that is capital protected. There is 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 this event you may be entitled to compensation from the Financial Services Compensation Scheme (FSCS), depending on your individual circumstances. In addition, you may not get back the full amount of your initial investment if the plan is not held for the full term. The past performance of the FTSE 100 Index and any of it shares is not a guide to its future performance.
The investments referred to in this article are 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 or any shares listed within the Index is not a guide to their future performance.