Protected Equity Products: Can you have your cake and eat it?

Loss protection and tax advantages …

Protected Equity Products (PEPs) are heavily marketed at this time of year.

They are promoted as an opportunity to benefit from share market growth, without the risk of losing capital. They involve borrowing up to 100% of the purchase price of a basket of shares for a minimum period (generally 3 – 5 years). You keep the dividends and any gains and are protected against investment loss.

The loan interest is also usually prepaid to bring forward a tax deduction and reduce a current year “tax problem”. What a deal – no downside and tax benefits!

However, even with this basic explanation, the alarm bells should ring for smart investors. PEPs play to at least one psychological bias (i.e. “loss aversion”) that investors should be wary of and contradict at least one of our wealth management decision making principles (i.e. “It’s about ends, not means”).

What’s the catch?

The downside is the borrowing cost. It includes a premium to pay for capital protection. This premium varies according to the term and volatility of the shares purchased.

It can add between 7-15% p.a. on a 3 year product and is not a tax deductible expense. So, if the typical loan rate was 7% p.a., the interest rate on the PEP would be around 14-22% p.a.

When you finance shares with a normal loan (i.e. excluding in built protection costs), you can make money, after-tax, even if the pre-tax return on the shares is the same or a little less than the pre-tax interest cost on the loan. Franked dividends and a favourable tax treatment of capital gains allow for this situation.

While PEPs also benefit from these tax effects, the additional costs of protection mean you need a very high return on your share portfolio to generate an after tax gain. If this was your expectation, you’re far better off holding an unprotected position.

The odds are against PEPs …

The table below shows average 3 year rolling returns for cash and Australian shares, beginning each month for the period from December 1979 to May 2006 (i.e. the last three year period ends in May 2009). There were 318 such periods, with cash always returning a pre-tax gain and shares showing this 94% of the time.

We used these asset classes to replicate a 3 year PEP and a comparative unprotected exposure. The inputs and outcomes for each are shown in the table below:

# representing a margin of 2.7% over Cash
^ representing a margin of 8.8% premium over the unprotected lending rate.

It shows that the return on the share portfolio exceeded the cost of the unprotected loan 60.4% of the time, but only exceeded the cost of the protected loan 18.9% of the time. These are terrible odds and a heavy price to pay to protect downside risk!

Do PEPs make sense?

PEPs play to investors’ desire to make “risk-free” gains and obtain a tax benefit. But they are not a serious way to invest in shares. Simultaneously eliminating the downside risk and expecting to get share market type returns doesn’t make sense. It’s the finance equivalent of alchemy.

At best, all you can realistically expect is cash type returns. To give yourself a chance of earning the higher expected returns of share markets, you need time, patience and a willingness to accept the accompanying risk.

But if your investment time horizon is short and/or your risk appetite is low, a PEP is an inappropriate investment solution. Borrowing to purchase shares is always a high risk strategy, and especially over the short term.

Offsetting this risk by adding a costly protection mechanism is extremely inefficient. It’s like driving your car with one foot on the accelerator and the other on the brake.

Summary:

1. Avoid focusing on minimising tax. You should aim to maximise your (risk-adjusted) after tax return. Tax can’t magically overcome inherent pre-tax disadvantages;
2. Don’t get seduced by complexity. It’s costly and there are usually simpler, more effective ways to achieve your objectives; and
3. Recognise that there are more efficient ways to reduce (long term) tax. Most of these, however, require some pre-planning to allow you to confidently take a longer term approach. An investment in good planning will help to avoid the costs of reactive decision making.