It is part of our survival instinct to protect our lives, our family, our wealth, but the unpredictable world we live in makes investing for the future difficult. For clients, our ever-changing world is a frightening place to put hard-earned funds, and for advisers, the markets’ unpredictable nature is especially unhelpful when trying to secure clients’ financial futures.
Thankfully, humans have long held the inherent ability to use our brainpower to protect ourselves. We have developed tools to hunt for food, built houses to shelter ourselves from mother nature, and developed laws to protect ourselves from each other. When investing, we need protection from the unpredictability of markets to build wealth and secure our financial future. Fortunately for us all, derivatives can offer this protection.
Derivatives take many forms, but they all derive their value from another specified asset or assets, and as with all assets, the value of a derivative can go up as well as down. The origins of derivative contracts can be traced back thousands of years. However, one of the first records of a derivative forward contract comes from ancient Greece. In the 4th century BC, there were contracts known as “kentenaria”, which were agreements to deliver a specified amount of olive oil at a future date, much like modern forward derivative contracts today.
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By fixing the value of olive oil at a future date, the derivative contract allowed ancient farmers to lock in a level of revenue for their produce, as opposed to being at the mercy of the olive oil market when their produce was ready for sale. By taking price out of the equation, where market prices would otherwise be unpredictable, these farmers could determine if their work and produce would be profitable and plan ahead.
Most of us are not farmers, but in a similar vein to derivatives contracts from over 2,000 years ago, modern derivatives can help to lower the impact of unpredictable markets by limiting the range of potential outcomes from investing.
Defined return investments are derivative-based investments, which we have used extensively in our funds for more than 15 years. As opposed to olive oil, the value of these defined return investments is determined by the performance of developed equity market indices.
The investments generally offer three possible scenarios: capital return plus positive return, capital return only, and capital loss. The potential return of these investments is pre-defined and contractual, much like a bond, but which scenario occurs and whether the return is paid is determined by the performance of the equity markets to which the investment is exposed. This exposure is what gives these investments sensitivity to equity markets.
Defined return investments can be altered to give them differing levels of equity market sensitivity. All else equal, investments with greater equity sensitivity offer larger potential returns, while investments with lower equity sensitivity offer lower potential returns. Derivative sensitivities are known as ‘Greeks’, which may be a reference to derivatives’ roots in ancient Greece. The key ‘Greek’ here that measures equity sensitivity is called ‘Delta’, which is similar to ‘Beta’.
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Defined return investments can be customised considerably, which is why we use pre-set rules when selecting them. For example, one of our funds has rules which state that the return of the investments must be paid so long as equity markets do not fall more than 25% at the end of six years. Additionally, the investments offer a second layer of protection, where the rules state that capital is returned so long as the same equity markets do not fall more than 35% at the end of six years.
We call the levels at which the return and capital must be paid, the barriers. The rules dictate the minimum protection levels, but the investments used generally offer greater levels of in-built protection, especially in a higher interest rate environment. For example, we target investment returns to best meet our fund’s annualised net return objective of 7-8%.
As with farmers in ancient Greece, modern derivatives can be used to protect investors from the unpredictability of markets. By providing more predictable outcomes, defined return investments enable both clients and advisors to have a clearer understanding of what to expect from investing. This shared knowledge helps to minimise surprises, improve decision-making during stressful market conditions, and satisfy consumer duty obligations.
Jack Roberts is a fund manager at Atlantic House Investments
