Guaranteed funds
What is the nature of the guarantee? What are the conditions that must be satisfied to allow the guarantee to kick in? Under what circumstances will the guarantee be terminated? Do I know exactly what is guaranteed?
What is a guaranteed fund?
A guaranteed fund is a type of collective investment scheme that guarantees to pay back a pre-determined percentage of the invested capital, subject to satisfaction of certain pre-determined conditions.
A guaranteed fund doesn't work exactly like a savings deposit. With a guaranteed fund, you are subject to the credit and solvency risks of the issuer of the underlying investment as well as those of the guarantor. A guaranteed fund is also not equivalent to a principal-protected instrument. The guaranteed amount may only be a percentage of the capital invested (which may be less than 100%) and is only available under specific circumstances.
What does the guarantee cover? There are different types of guarantees; check carefully to find out which is which. In general, the guarantee will cover one of the following:
1. The guarantee may cover the shortfall between the original offer price per unit and the market value of the underlying investment of the fund per unit upon maturity of the fund. For instance, if the offer price is $10 per unit and the market value of the investment of the fund per unit is $8, the guarantee will result in the payment of $2 to the investor upon maturity.
2. The guarantee may cover only part of the offer price, which is the shortfall between a percentage of the offer price per unit and the market value of the investment of the fund per unit upon maturity of the fund. Assuming the percentage is 90% and the offer price is $10 per unit, the guarantee will represent a payment of $1 to the investor upon maturity if the market value of the fund's investment is $8 per unit.
3. The guarantee may provide a guaranteed coupon on top of one of the two types of guarantee described above. In this case, the guarantee includes an additional coupon, which may be distributed at pre-determined dates before maturity of the fund, subject to satisfaction of certain pre-determined conditions.
What does the guarantee NOT cover?
A guaranteed fund doesn't mean that an investor will always get back the invested capital at maturity. In addition, there are limitations as to how the guarantee applies. In many cases, if the fund manager is removed from managing the fund prior to maturity, the guarantee will no longer be valid. In other cases, the guarantor is not liable to fulfil its guarantee obligations if the issuer of the underlying investment defaults, causing the fund to be terminated prematurely. In other words, the guarantor does not guarantee the creditworthiness of the issuer of the underlying investment.
What are the major risks of investing in a guaranteed fund?
1. Credit risk of the guarantor. You are taking the credit risk of the guarantor. If the guarantor fails to fulfil its obligation for any reason (such as, its own financial difficulties or closure), your investment will not be covered by any guarantee, whether or not the pre-determined conditions have been satisfied. The amount of money you then will receive at maturity will then depend on the market value of the underlying investment of the fund. If the underlying investment has fallen a lot in value, you will lose a substantial amount of your investment.
2. Credit risk of the issuer of the underlying investment. You also are taking the credit risk of the issuer of the underlying investment. If it fails to perform its obligations, you will not receive the amount due from the issuer, as reflected in the valuation of the underlying investment it issues. This will have a negative impact on your investments. The impact could be substantial as the underlying investment represents the bulk of the investment of the guaranteed fund. For more details on risks of a guaranteed fund, please refer to the following pages.
3. Market risk. A guaranteed fund is exposed to the economic, political, currency, legal and other risks of the specific market(s) in which its underlying assets are invested.
What are the conditions that must be fulfilled for the guarantee to apply? Pre-determined conditions must be met although they vary from fund to fund. It is generally required that you hold your investments in a fund until a specified date, such as the maturity date. If you redeem your investments before the specified date, you will not get the guaranteed amount back. In addition, if you choose to have your investment redeemed before maturity, the amount of proceeds you receive will depend on the value of the underlying investments of the fund, which is exposed to the market conditions at the time. Therefore, you may get back an amount that is substantially less than the amount you originally invested.
Another common condition for a guarantee is no early termination of the fund. If a fund is terminated early by the fund manager before the maturity date due to (a) a substantial reduction in the fund size to a level below the minimum requirement, or (b) replacement of the manager, or (c) breach of any pre-determined conditions, then the guarantee will not apply.
What are the worst case scenarios?
You may lose up to 100% of your investment if the following occurs: (1) the value of the underlying investment of the fund has dropped to zero and the guarantor fails to fulfil its obligation as a guarantor. (2) the issuer of the underlying investment defaults, triggering early termination of the fund and rendering the guarantee invalid. In that case, neither the guarantor nor the issuer of the underlying investment will make interest payments. You also could lose up to 100% of your principal.
Remember, a guaranteed fund may not be suitable for everyone. You must understand the nature and restrictions of a guaranteed fund and as well as your personal circumstances before investing. Always seek advice from a professional adviser.
