Comfort rules, but bonus is essential

Solange Rouschop

1995:Received a master's degree in economics from Tilburg University, then joined ABN Amro Bank as a manage ment trainee.

1996:Became product developer for ABN Amro Asset Management.

1999:Programme manager at ABN Amro Asset Manage ment Amsterdam.

2000:Head of the structured asset management department at ABN Amro in Hong Kong.

GUARANTEED FUNDS will never stand out as star performers, even in a bull market for equities, gold or whatever underlying theme a manager chooses for a particular fund.

These are conservative investment vehicles, promising to return all the investor's capital after a specified period. To achieve this, and to offer an acceptable return on savings, managers direct most of the money invested in guaranteed funds into fixed income instruments.

To add excitement, managers blend this dependable but unexciting paper with some exposure to stock markets, commodities or currencies. If the underlying market moves the right way, investors share in the profit. This is an indirect way of playing any market - returns would be far higher by investing directly in the market or commodity.

But investors are a frightened bunch these days, and they happily sacrifice higher returns for the comfort of knowing their capital is safe from adverse market movements. Last year, guaranteed funds were the most popular type of unit trust in Hong Kong, accounting for a shade under 60 per cent of the industry's net inflows, according to the Hong Kong Investment Funds Association. Guaranteed funds worth US$3.37 billion were sold in Hong Kong last year, with net sales of US$2.72 billion.

One manager active in the guaranteed funds market is ABN Amro, which has raised about HK$3.3 billion through these vehicles in the past two years. ABN-Amro last week launched the Korea Bonus 104 per cent Guaranteed Fund, which features a guarantee of the original capital plus a 4 per cent return at maturity, and a potential bonus of up to 71 per cent, depending on the movement of the Korea Composite Stock Price Index (Kospi) 200.

Solange Rouschop, the bank's head of structured asset management, said a good bonus theme was essential for a guaranteed fund's success. And while investors had the choice of buying into money market funds to gain access to wholesale interest rates, their returns would fluctuate with the market, whereas with guaranteed funds the returns were locked in at the time of purchase.

ABN Amro's house view of South Korea is broadly positive, according to Ms Rouschop. Positive factors included a healthy level of domestic consumption and low stock market valuations, she said. 'The South Korean market contains a number of world-famous companies which are global leaders and the export story is still healthy. It is not just exports to the US and other leading economies, but to Asia including China. That makes South Korea less sensitive to the global environment.

'We have a good outlook for South Korea, even though in the very short term, obviously, North Korea is a worry. We think the situation will be resolved in a peaceful manner, but we don't have a crystal ball.'

The Korea Bonus Fund is denominated in US dollars, with 3.9 years to maturity. The bonus - a maximum of 71 per cent - is earned in the somewhat unlikely event that the Kospi 200 remains stable or rises each month. For every month the index falls, the bonus is adjusted downwards.

Ms Rouschop said the fund was suited to investors who shared ABN Amro's reasonably positive outlook for South Korean stocks. 'If you are really bullish and you think South Korea is going to deliver 20 per cent for the next four years, you are better off with a product that gives you all the upside potential. Our house view is not as bullish as that.

'This type of product would suit someone who is not expecting extreme returns from South Korea but expects the market to be stable or positive.'

With any guaranteed fund, there is the chance the underlying market will move the wrong way. Ms Rouschop said that, in the worst case, investors would still receive their guaranteed return and a better return than a bank deposit. Achieving this kind of gain was a fundamental aim in designing a guaranteed product.

Although guaranteed funds were at the low end of the risk spectrum, there was some risk involved in the structure's market exposure (or exposure to some high-yielding instrument) and the counter-party risk of dealing with the issuer, although in ABN Amro's case investors have the comfort of its AA rating.

Guaranteed funds have attracted many first-time investors to the unit trust market, according to Ms Rouschop.

At the heart of any guaranteed fund aiming to take advantage of the movement of an underlying market, currency or index is a derivative contract (in the case of ABN Amro's Korea Fund it is an option) which promises to deliver the appropriate benefit to the fund in certain market conditions, such as when a market moves within a fixed range for a specified period. This is the mechanism for delivering the bonus return to the investor.

The provider, or writer of this option typically hedges its own exposure to minimise its risk. Ms Rouschop said guaranteed funds had evolved along with trends in the derivatives market. Because of the need for a derivative instrument within each fund to deliver the bonus-return component, only liquid derivatives markets could be used as the subject or theme of guaranteed funds. Many investors would find a China theme guaranteed fund attractive, but without appropriate liquid derivatives markets, this was not yet possible.

ABN Amro has an internal derivatives pricing team which calculates a preliminary target value for the option product required for any new guaranteed fund prior to its launch. Negotiations can then proceed with potential providers closer to the product launch.

Ms Rouschop said guaranteed products were unlikely to disappear from the investment scene, even when bull markets returned.

'If you are very bullish on a market, then you should buy the market without any guarantee. Obviously the popularity of guaranteed funds would decrease at such a time but that does not mean they will not exist any more or there will be no demand for them. And if interest rates are higher, you can offer a lot more upside potential on your guaranteed fund because the guarantee is covered by fixed income, which will be giving you a higher yield. You would need to invest a lot less in fixed-income paper, which would leave a lot more for upside potential.'