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Protect your investment principal with a capital protection program

August 6, 2007

 

The following discussion outlines a method by which investors can protect the principal of their investment. It is not intended to downplay the risks of futures investments, which can result in substantial losses, and it is important to note that no investment method can guarantee against the risk of loss.

What if you could make an investment in which there was no risk? That is, what if you could put up a certain sum to invest, and you were guaranteed to at least receive that initial amount, the principal, back. This is a bit of a dream scenario for investors - to risk nothing, and gain everything. And while that is never really a reality, there are some ways investors can come close to that.

There is of course the ability to risk nothing and make a small amount by investing in US Treasury securities (US Government Bonds, T-Bills, Notes, etc.) While such investments technically do have risk - they are universally accepted and referred to as zero risk investments given that the only way for them to not pay their interest and principal would be the failure of the US Government - an event considered so remote that it is not considered possible.

So, there is the possibility to risk nothing, and make a small amount with US Treasuries - but the problem most investors have with investing in US Treasuries is that the "small amount" they offer is not worth the fact they risk nothing. In some cases, the return barely keeps up with inflation.

Investors looking for a little higher return than treasuries therefore start to accept more and more risk for a hopefully higher and higher return above the treasury returns. In theory, the higher the return amount above the treasury returns, the more risk they are taking on - up to the point where they could lose their entire amount invested, or even (when trading futures, options, and other derivatives) more than their initial investment.

Capital Protection

And so the game is played, risking money to make money. But what if you want the best of both worlds. That is, you want to risk nothing, but still want to make higher returns than US Treasuries. That seems like an impossibility, and in many investment arenas it is. You can't buy a stock and guarantee you get your investment amount back, for example. But there are some investment programs out there, some offered by heavyweights such as Fidelity and Merrill Lynch, called capital protection programs which aim to do just that.

How a capital protection program (or, alternatively, "principal protection," "capital preservation," or "guaranteed" fund) usually works is that the issuer of the program will guarantee your principal (your initial investment) if you agree to participate in the program for a set period of time (usually 5 to 10 years). The manager then invests your money in a mixture of bonds and other investments (usually index or sector tracking stocks).

How do they do it? The trick is, they invest just the right amount in the bonds, that when they come due - they will equal your initial investment amount, leaving the rest of the capital available to be at full risk. The manager could lose 100% of the money not allocated to bonds, and after 10 years - the account would still have the full amount of the initial investment due to the interest on the bond.

Do it Yourself

This type of principal protection seems like a great idea - and it is. The problem is, whenever someone puts one of these programs together, they want to get paid for doing their work and for issuing you a "guarantee". The fees can be steep, as much as 2% per year or more, with even higher fees for getting out of the program early.

And while you may need someone else's expertise in putting together a capital protection program to invest in stocks - you can create your own capital protection program for your futures investments and not pay any such fees for setting it up.

The way to easily accomplish this on the futures side centers around the the ability to use US Treasuries as collateral for futures trades. As many of you who read this newsletter know - you can hold US T-Bills in your futures account and earn an extra 4-5% per year on your cash balance held in the account. Click Here to view our newsletter on T-Bills.

T-Bills are structured like Zero-coupon bonds, which unlike most bonds, pay no interest (they have zero coupons). Instead, you buy them at deep discounts below face value. When the bond matures, you receive the face value, which represents the principal plus interest that has accrued. So, as an example, an investor would buy a 180 day, $100,000 face value T-Bill for approx. $97,500. At the end of the 180 days, that T-Bill would be worth $100,000.

To use a T-Bill for your own capital protection program - you would purchase the $100,000 T-Bill for $97,500, and risk only the $2,500 left over in your trading. If you lose that amount, you stop trading, and wait till the 180 days is up for the account to be worth your initial level of $100,000 again.

The problem with using a 180 day T-Bill for a capital protection program is that there is only a very small discount to the face value with just 180 days til maturity. You are basically only getting a discount on 1/2 year's of interest. So to really make T-Bills work for a capital protection program - you need to go out five years or more. The problem - there is no such thing as a 5 year T-Bill.

5 and 10 Year STRIPS

To combat the problem of no long dated T-Bills, we recommend using 5 and 10 year STRIPS to construct a capital protection program. STRIPS is the acronym for Separate Trading of Registered Interest and Principal of Securities. Click here for more information on STRIPS. So a 5 Year STRIP is just the principal part of a 5 year bond, and it acts just like a 5 year T-Bill would. That is, you buy it at a deep discount from its face value and it matures over the next five years to that face value. Here comes the best part - you can use Treasury STRIPS as margin for your futures trades at each of the clearing firms Attain works with.

So, your capital protection program would look something like this. You could buy a $500,000, 5 year Treasury STRIP today for approx. $390,000. That would leave you with $110,000 in the account as risk capital, and a full $450,000 as margin (90% of the total account value). You could trade a $500,000 portfolio of 5 different CTAs easily enough with the $450,000 in margin - while you could endure a loss of 22% ($110,000) and still end up with your full $500,000 in the account after 5 years due to the STRIP.

Of course, the even better scenario is that the portfolio goes on to make money - and then you have in effect gained the full performance of the portfolio on top of the $500,000 you get back after 5 years. This ability to use the STRIP as margin sets futures well ahead of capital protection programs in other securities, where they can only invest the amount left over from the purchase of the zero coupon bond. In futures, you can invest the entire amount in the portfolio you desire, AND invest in the STRIP simultaneously.

You can also be flexible with your capital protection program and instead of trying to lock in 100% of your initial investment - lock in 120% of it, or only 80% of it, and so on. You could also layer new STRIPS on top of the initial one, booking all profits into STRIPS and trading the discount amount, and so on. This flexibility is due to the fact that you are in charge of deciding how much of a STRIP to buy, and when to cut off the active trading. This is also one of the dangers of this approach. There is no guarantee of your principal. You are merely setting up a way for you to protect the principal. The investor would still have to cease trading when and if the cash amount, the difference between the purchase price of the STRIP and the face value, is completely lost.

Another danger is that you will need to tap into your principal before 5 or 10 years is up. There would be no penalty fees as there are in principal protected mutual funds and the like, but the price of the STRIP could be well below where you would expect it to be based on the movement of interest rates.

The last caveat is that it would be nearly impossible to cease a portfolio of multiple trading systems and CTAs on a dime. You do have daily transparency with managed futures investments. But in all likelihood, you would be basing decisions off of the previous day's activities, and the losses in the portfolio could therefore overshoot your stop trade point by a good amount.

In conclusion, you don't need to pay high fees and be locked into a complicated protected program or fund to get the benefits of a capital protection program. You can create one yourself through a futures account at Attain and 5 or 10 year STRIPS. This is admittedly a bit more complicated than most of our topics, so please don't hesitate to call us at 800.311.1145 or email invest@attaincapital.com with any questions you may have on this