Should you add defined returns to your investment portfolio?

Although this is dependent on market performance, it does essentially mean that you could invest in the stock market with a guarantee that if it drops by up to 40% at end of six years, you would still you get your money back.

What are the benefits of Defined Returns?

The nature of defined returns funds makes them much more predictable and the pre-determined rate of return offers an element of downside protection. This protection distinguishes them from other investment strategies and makes them a good addition to a portfolio to balance out more volatile funds. It is estimated that returns from equities will decrease in the coming years, meaning they may become an increasingly popular investment choice.

What makes the returns defined?

The money-back protection is provided by autocalls, which are part of a wider group of investments, known as structured products. Although this is not the most exciting corner of the market, it is worth $7trn, making it more than double the size of all hedge funds.

Autocalls work by paying a fixed rate of income each year, dependent on the level of the stock market.   

It is useful to consider an example to understand exactly how autocalls work.

Let us say that you bought a six-year autocall from Morgan Stanley, when the FTSE is at 7,500, and the autocall pays 10% per annum. If after one year, the FTSE 100 is above the original level, then the product would mature and you would receive the original investment, plus 10%. If the index is below 7,500, then you would wait another year for the next review.

This process would then continue for six years and there would be three possible outcomes on the last day of the autocall, which would be exactly six years from when it began. Firstly, if the FTSE Index is above 7,500, then you would receive the original investment, plus 60%. This is because it would be 6 years of 10% per annum. Alternatively, if the index is below 7,500, then you would get your original investment back with no extra return. However, if the market has fallen by more than 40%, you would only receive the value minus the percentage fall of the original investment.

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When should I invest?

Autocalls work particularly effectively when market returns are low because the stock market only has to go up by a small amount to receive good returns.

This means that it is still possible to achieve good returns when the market is slow, if you invest in these products at a good time. However, it is also okay to invest at other times, as you would still get similar returns to the market, with the added reassurance of capital protection.

Are there any pitfalls?

Due to their predictable nature, defined returns funds are often more expensive to invest in originally. However, the increased cost can be balanced out by the increased level of assurance that investors get by knowing what they are likely to receive back.

By nature, and name, the returns are defined, which means they are fixed. As a result, if it looks like the stock market is going to rise further than the autocall is set to pay per annum, then your money could be better invested in an index tracker fund.

Something else to consider is that you would not receive the dividend yield of 3.5% paid by the FTSE 100, via an autocall.

This is due to the fact that the value and return of autocalls are determined by the capital-only level of the FTSE 100. To give an example, this yield could amount to over 20%, which would not be gained. However, this could be received via an index tracker fund.

Autocalls are not completely risk free, as they are essentially a contract with the business they are invested with, meaning that if this business were to go bust, there is a risk that all the investments will become worthless.

Overall, as with the majority of investment decisions, there are benefits and drawbacks.

However, defined returns funds can be included in every investor’s portfolio, as they are a great balancer, helping to create a well-rounded portfolio and offering a traditionally less volatile option for investors looking for a lower level of risk.

Neal Foundly is an investment analyst at Equilibrium Financial Planning

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