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Lifting the Bonnet on BCP's - Guaranteed Absolute Return Fund

Global equity markets have delivered zero returns since the late 1990s.

Property has been a disaster since 2007, cash deposit rates are at generational lows depriving investors of safe income, and following the global credit crisis in 2008 and the economic collapse in Ireland investors are extremely risk averse. In response, Irish investors are buying guaranteed investment products by the truckload and the question is: are guaranteed products the holy grail of investing or simply the solution product sellers have drummed up to stay in business?

Against that backdrop, it is worth lifting the bonnet on a recent offering from BCP Asset Management - its Guaranteed Absolute Return Bond 4, which remains open to investors until 29th February next. The fund offers a 100 per cent guarantee, access to an underlying Lyxor Asset Management hedge fund on a 5-year term with 90 per cent participation in the upside and a partial early exit option. The underlying Lyxor fund has generated returns of 11.2 per cent per annum compound since 2005, even after its 2 per cent annual management fee and 20 per cent performance fee. This is how it works.

100 per cent of investors' monies go to Bank of Ireland (the counterparty) which places 71 per cent on cash deposit, which, with interest, rolls up to 100 per cent after the 5-year, 3-month period to provide the guarantee. BCP earns 2.15 per cent for designing the product and intermediaries can earn 3.25 per cent for selling the product on to their clients. The balance of the monies, 23.5 per cent, presumably goes to Societe Generale, the parent company of Lyxor Asset Management, which then buys a (geared) option on the underlying Lyxor fund.

As I see it, the following are the issues facing investors in this fund (i) do you want BOI as your guarantor? (ii) can the hedge fund replicate its past returns? (iii) how sure can the investor be that he/she is going to share in 90 per cent of any upside? and (iv) is there sufficient disclosure to ensure investors understand what it is they are investing in?

With the ECB underpinning the Eurozone banking system, the risk of BOI as a counterparty now looks minimal. In terms of the performance of hedge funds, since 2003 the HFR Global Hedge Fund Index has gained 0.6% per annum compound. Hardly inspiring! That, of course, is an average of a range of hedge funds tracked by Hedge Fund Research (HFR).

There is a wide range of investment strategies employed by hedge funds to try and generate a positive return irrespective of market direction. That's what makes them a choice as an alternative asset class - they offer the potential for returns above cash deposit rates and returns that are uncorrelated to other asset classes. For that reason, they offer diversification.

The underlying Lyxor hedge fund in the BCP bond is a systematic, trend-following hedge fund that can be long one market or financial instrument and short another. Said another way, the fund has a defined formula for seeking out trends in markets - both uptrends and downtrends. The last five years have been perfect for this strategy. Volatility in markets and across many financial instruments has been well above average, trends have been unusually well defined and my guess is the Lyxor hedge fund has made hay while the sun shone. Can the fund replicate its success over the next five years? No one can say. Equity markets have delivered returns of 9% per annum on average over the past 100 years. Hedge funds, in aggregate, have never proven capable in the past of bettering this long-term statistic, and, of course, they carry considerably higher costs. Only the use of leverage can improve returns further and leverage means added risk. In fact, if the Lyxor hedge fund delivered minimal returns or even losses over the next few years, that would not be a sign of failure. It is the nature of a hedge fund. Do private investors understand these issues? It is unlikely that they do.

Presumably Societe Generale charges a fee for the option on the fund (not disclosed). But my understanding is that the 90 per cent participation rate cannot be guaranteed as it is dependent on the volatility in the fund. It's not a major issue and, in any event, the BCP brochure refers to the fact that the 90 per cent guarantee is of the average of the final 12 months fund price.

For me, the following is the nub of the issue. If an investor is looking for the diversification that hedge funds offer then why is there a need for a guarantee? Guarantees costs money, and, like insurance, the cost of hedging goes up when everyone wants it. Admittedly, in this case, with the Irish banks desperate for customer deposits, the hefty entry costs to the BCP fund of 5.4 per cent are being picked up by Bank of Ireland. So good luck to BCP, I can't fault the firm for that.

I see the guarantee as a distraction, a tool that product sellers in Ireland use to sell to a risk-averse public. But investors must remember that, on average, better than cash deposit returns can only be obtained by taking on risk. The trick is to understand whether the asset in question is priced properly relative to the risk involved. That is surely the role of an investment advisor - to assist clients in this regard. How can the industry offer this service if it gets paid from the product and not by the client?

For as long as the Central Bank (regulator) continues to allow investment intermediaries to be product sellers, nothing will change. In my view, few genuinely independent investment advisors would have reason to recommend a guaranteed fund, not to mind a guaranteed hedge fund. This is not a criticism of BCP: the firm, whose offering is a step above most traditional stockbrokers, is simply reflecting a system that does not serve the consumer but itself.

Rory Gillen
26th Febuary 2012