How to create better portfolios for your clients

MoneyMarketing spent several hours last month learning about Absa’s new Fund Linked Solution strategies. Advisers and DFMs will soon be given the opportunity to get to grips with these highly sophisticated strategies through no less than 10 e-learning modules. Yes, it’s complicated! But the strategies could just turn out to be a gamechanger when it comes to creating truly amazing portfolios for clients.

BY JANICE ROBERTS

Financial advisers and DFMs change the risk/return profile of their clients’ portfolios when the investment outlook changes, by trading out of one fund into another – but what if they had access to strategies that could change the risk/return characteristics of their portfolios without having to affect CIS transactions? While this has always been possible for those who have a minimum of R10m to invest, Absa Structured Solutions is now ‘democratising’ these strategies by making them widely available for amounts of R100 000 – and perhaps even less in the future, given the advance of both technology and platforms.

“We want to hand these tools to the people – advisers and DFMs – who make investment decisions on behalf of investors, so they can make better choices, and so they can create better portfolios,” says Adam Reeves, Distribution Specialist at Absa Structured Solutions. “All these strategies have specific characteristics, and they can be changed at any time, providing full flexibility.”

Funds that may be used in the different Absa Fund Linked Solution strategies may either be Collective Investments Schemes (long only, Retail Hedge Funds or ETFs), segregated portfolios, or indices.

Delta 1 note

Reeves explains that a Delta 1 note issued by Absa is the starting point for all Fund Linked Solutions available on the Absa platform. While investors purchase an Absa issued note, it’s the bank that owns the units in the underlying funds, not the investor. What the investor owns is the note that references the portfolio of the assets.

“When you start to introduce protection, risk managed or leverage strategies, it’s the bank that is actually assuming risk. Absa will then have to dynamically trade those portfolios and provide protection on them – and we need to trade them in and out of a protection asset that is cash-like, when appropriate.”

The notes are available via LISPs, with a large universe of funds available – however, any new funds will need to go through a due diligence process. “We will have a look to see if they’re regulated funds,” says Reeves. “How stable are they? Have they been around a long time? Are they priced daily? What’s the liquidity like? Is there an appropriate diversification of component assets? We can then assume risk on that fund. If it’s a R20m fund, there will be less appeal unfortunately, because it’s not going to be suitable as the bank may only own a certain percentage of the fund for risk management purposes.

All these strategies have specific characteristics, and they can be changed at any time, providing full flexibility

The Delta 1 note – or the wrapper – is the default strategy when only exposure to the desired reference portfolio is required, or if the time isn’t right for future strategy application. Rules may be encapsulated into the Delta 1 note’s strategy based on the advisers’ wishes. For instance, there may be an automatic rebalance over specific time periods, or a rebalance may take place when specific allocation weightings exceed or fall below thresholds.

Constant Proportion Portfolio Insurance

Within Absa’s Fund Linked Solution strategies, portfolios can be protected by two different protection mechanisms, one of which is Constant Proportion Portfolio Insurance (CPPI), also referred to as ‘term protection’, as it applies the protection strategy over a fixed term. At inception, the investor specifies a monetary protected amount, which is the minimum amount the investor will receive at the end of the strategy term.

“This strategy is for someone who has a particular investment objective in time,” says Reeves. “They might be wanting to emigrate in five years’ time, or they might be looking to retire in three years’ time – and they want certainty.”

Term-based protection is achieved by dynamically allocating between higher-risk performance assets and lower-risk protection assets. This is done within the note so that no decision has to be made by the investor or the adviser. The protection can be removed at any time, while loans may in future be taken out against the portfolio that will assist in making financial planning more flexible.

To determine how much to allocate to the performance asset and the protection asset to achieve the protected amount, the current value of the reference assets, the present value of the protected amount, and the multiplier of the performance assets are required.

“The multiplier of the performance asset is really just a mathematical ratio that illustrates how volatile and risky the underlying portfolio is,” Reeves adds. “The higher the multiplier, the lower the risk of the fund.”

But what happens if there’s a so-called knockout event? “This means the market goes down so far that everything has been allocated back to the low-risk protection asset, there is no room now for the performance asset,” he adds.

This means that the investor will receive the protected amount at expiry. The investor could unwind the strategy and receive the present value of the protected amount and sell the note or invest in another strategy.

Time Invariant Portfolio Protection

Another protection mechanism within Absa’s Fund Linked Solution strategies is the Time Invariant Portfolio Protection (TIPP), also referred to as ‘continuous protection’, as it does not have a fixed or defined term. It is achieved by dynamically allocating between a higherrisk performance asset and a lower-risk protection asset. The protected amount is the minimum amount the investor receives when choosing to end the TIPP protection strategy.

“An investor will turn around and say, ‘I’m happy with some risk. I don’t want to go the CPPI route where protection is only provided at the end of the elected investment term and lock in what my minimum level is going to be over a period of time,’” Reeves says.

“The investor wants to set a trailing safety net. This is like a stop loss on a fund that’s used, for example, by someone who is a little risk averse, but also wants decent upside potential in his fund – and if the wheels fall off, at least he knows he has some protection. If there’s another pandemic, for instance, the investor wants to make sure he gets out with something, and this can be set upfront at 80% or 90% of the initial amount invested, depending on personal choice.” He adds that protection can be removed at any time, while there is no expiry date.

Risk managed strategy

Included in Absa’s Fund Linked Solutions is a risk managed strategy. Risk can mean capital losses or drawdown, or it can mean volatility of returns. Investors want an element of certainty in their investments so they can decide on whether specific investments are suitable for meeting their investment objectives.

“If someone is close to retirement, they don’t want to own an inconsistent performing equity fund because it’s

not going to assist them in their financial planning,” Reeves says. “People have specific investment objectives they’re trying to achieve, and they want certainty out of their investment. A risk managed strategy can set the level of volatility that the investor is comfortable with.”

Volatility is a quantitative measure of risk and tends to increase with a higher equity component. A volatility ratio is used to determine the appropriate reference asset allocation between the performance asset and the protection asset. The risk managed strategy allocates the reference assets based on the volatility ratio.

Leverage strategy

Absa’s Fund Linked Solution leverage strategy means that investors may invest with borrowed money to increase their total exposure to their investment assets. The suitability for leverage and the number of times leverage is allowed is dependent on whether the performance asset is daily priced, liquid and tradable. The strategy can be used in combination with other strategies, specifically with a protection strategy.

“Absa provides the loan, which is invested alongside the capital of the investor. The bank measures risk and lets the investor borrow an amount of money based on the riskiness of the underlying investment. The loan amount will be higher for a stable investment and smaller for a more risky investment. We don’t want investors to suffer excessive losses and we don’t want to be out of pocket either,” he says.

Part of this strategy is the ongoing loan amount management, meaning that the relationship between the investor capital and the loan amount must be managed and rebalanced on an ongoing basis to maintain the appropriate ‘times leverage’

relationship over the leveraged investment period.

There are two methods available for the ongoing management of the loan amount in a leverage strategy: the constant proportion method, and the volatility control method.

“The constant proportion method means that no matter what happens in the market, the ratio between the loan amount and investor capital will remain constant, irrespective of whether the market is going up or down. The investor, who is really bullish and expects the market to go up, wants two times leverage. But if the market goes down, this investor will therefore have to bear a double loss on his portfolio.” In reality, this will be used by the expert advisor or manager who is comfortable in making market timing decisions.

The volatility control method, however, means that the strategy will vary the times leverage amount subject to market conditions. “If the market is becoming choppy, the investor’s times leverage will be turned down, and if the market does go down, the investor doesn’t suffer so much of a loss,” Reeves adds.

Should the investor decide to change (either increase or decrease) the volatility target within either method during a leverage strategy, this decision effectively ends one leverage strategy and starts a new leverage strategy. The investor has the discretion to end the leverage strategy at any time. The loan capital, including the rolled-up interest, is settled (from the gross exposure when the leverage strategy is ended). The remaining investor capital can then be deployed in a new strategy or withdrawn by the investor.

Reeves explains that the 10 e-learning modules have been created for advisers to understand the concepts as well as the risks of Absa’s Fund Linked Solution strategies. “Advisers first have to pass one module before they can proceed to the next one – these strategies can start to get complex, especially if you start combining them.”

He adds that combining strategies allows the adviser to create very specialised portfolios to suit their specific investment requirements, and this is where the full flexibility of the Absa Fund Linked Solutions offering can be utilised.

ABSA’s new Fund Linked Solution strategies are set to become available in the first quarter of 2022.

Adam Reeves, Distribution Specialist at Absa Structured Solutions