David Stevenson: Why a zero return looks attractive in volatile times

I haven’t regaled you with my views on how 2010 will develop – because, as far as I can tell, the only certainty is that markets, like my children, will continue to be both annoying and unpredictable. In fact, the only forecast I will hazard is that markets will be very volatile in 2010. Prices will be affected by concerns over asset bubbles and the inevitable withdrawal of quantitative easing, plus fears of rampant inflation.

I don’t know whether any of these fears will actually be realised, but I do know that they are growing every day. They are bound to contribute to many
a scare, and more than
a little turbulence.

As predictions go, this one is perhaps anodyne and obvious. But I think it has two consequences.

First, there will be a greater dispersion of returns across asset classes. Second, there will be more demand for income or defined returns.

To me, a greater dispersion of returns means that investors should seek some protection via defensive stocks, such as utilities and dividend-paying blue-chips. This view was recently summed up by Cazenove’s star fund manager, Tim Russell, who runs the absolute return mandates.

In an interview last week, he said: “There is a very reasonable chance that the risk appetite which has been evident in the market [in 2009], will be disappointed. My central view is that I’m not sure it really matters whether we get growth coming through at 3.5 or 4 per cent next year, or if it retreats, but I think the risk trade that we’ve had on is likely to moderate. Actually, the markets were very like that in 2004. Having had a very strong cyclical recovery in 2003, the market broadened out, and investors started thinking ‘what’s wrong with buying defensives with decent yields and sensible valuations?’.”

As best guesses go,
I think this is about right. So I think investors should be rather unadventurous in 2010 and hunt down those blue-chip progressive
dividend payers.

I also think we should seriously look at any sensible ideas about income. One neat idea that has just cropped up on my radar comes from French bank SocGen, via its listed structured products department. It’s a range of 11 products (with more to follow) that effectively give you a defined return based on individual shares rather than the aggregate market return. 

These products are
technically “synthetic zeros” – types of structured product that pay a final capital return at a future date linked to the performance of underlying shares. For SocGen, the underlyings range from Barclays through to BA and offer an interesting, defined return over two years.

Let’s take Prudential as an example. I happen to think its shares are reasonably priced but if you buy SG’s SZ09 product for £6.37 a share (which is also the Pru’s share price), you buy the chance to make £7.80 a share in April 2012, as long as the actual Pru share price isn’t below £4.50 on that maturity date. If you do the maths, that represents a total return of
22.45 per cent or just
under 10 per cent a year.

Alternatively, potential returns of more than 30 per cent over two years are available from products based on shares in Man Group. In effect, you’re giving up the income from the shares and any additional capital gain by only taking the defined return.

Of the initial 11 synthetic zeros, I’d suggest only those based on the Pru, Man Group and possibly Land Securities look attractive based on current valuations and the likely volatility. In the case of the first two products, the downside barriers are 30 per cent below the current price, giving you some protection, and the upside is a compound annual return of between
9 and 12 per cent a year.

I am rather more nervous about products based on shares in miners, such as Rio and BHP. They could easily end up below their 30 per cent downside barriers at maturity, so you need to be cautious.

Nevertheless, I’d suggest that moderately adventurous investors could quite easily put together a nice basket of products based on three or four decent blue-chips with lower volatility – and look forward to an average annual return of well over 10 per cent in the next two years.  

It is still early days for these products, and more are planned. I’ve heard that SocGen is already pricing one based on HSBC shares. But if I were at SocGen,
I’d think about launching some for big utility stocks, with potentially higher yields and better barriers.  

adventurous@ft.com

SocGen’s new range of listed structured products is based on large UK blue-chip shares, but is not without risk. If the underlying share price breaches the downside barrier at maturity in two years’ time, investors lose £1 for every £1 fall in the underlying share price from its starting level. So, a lower-risk approach might be to simply buy the underlying ordinary shares, pocket the dividends and wait for the share price re-ratings that Tim Russell and I think are coming for large UK defensives. That way, the upside wouldn’t be limited and investors would get the (hopefully) reliable dividend income. You could also try to replicate SocGen’s products yourself, by writing your own options contracts on the underlying shares to earn income – although I think you’d struggle to match SocGen’s returns.