Lock-in Funds: Protecting capital but compromising growth

by Levi Folk

Lock-in principal protected notes (PPN) are another twist on an already complicated product market. While plain-vanilla PPNs offer just principal protection over the life of the note, lock-in notes protect capital – principal and capital gains – on a daily or monthly basis. While protecting capital is always a good idea, capital guarantees are expensive because they requires a highly conservative asset mix between equities and bonds and can seriously compromise growth.

Just how does this capital protection work? It is very similar to plain-vanilla principal protection which focuses on the cost of a zero-coupon bond with a coincident maturity date as the note. A zero-coupon bond, as the name suggest, pays no coupon over its life. Rather, its yield is determined by its price discount to its par value at maturity. For example, a zero coupon bond that pays $100 in one year and yields 10 percent costs $90.91 today ($100=$90.91*1.1). With a two-year maturity date and 10 percent yield, it would cost $82.64 ($100=$82.64*1.1*1.1) and so on.

With a plain vanilla PPN, the maturity date and the principal amount are known at the start and do not change. In a lock-in note, the amount of capital that needs to be “protected” or “locked in” changes every month, so the amount of capital that needs to be directed toward the bond changes. In all cases, as the maturity date is reached, more and more capital is pushed toward the bond to ensure that the value of the note is maintained for maturity. It is for this reason that these lock in notes are often marketed as life cycle funds with staggered maturity dates: Investors choose the fund or note with a maturity that fits their life needs.

Since the lock in feature is more ambitious than a plain vanilla PPN in that it is continually protecting the growing capital, more money must be directed toward the zero-coupon bond on a regular basis. Therefore, less money is available to be invested as equity capital. With less money in the market, its stands to reason that returns will be lower than is otherwise the case.

The exception to the rule is a lock in note with a very short dated maturity period that matures in a bear market. In this case, the lock-in feature will have protected capital in the midst of a bear market and will have outperformed other unprotected investments in the same or similar equity investments. However, even in this case, the value of these notes is questionable because they offer very little equity exposure in the first place. (The moral here is that investors with short time horizons should not be invested in the stock market and principal protection does not circumvent this issue.)

This lock-in fund structure has a precedent in Europe with 50 varieties of Target Click Funds being managed by ABN AMRO of the Netherlands since October 2000. Since these funds’ inception dates are at the start of one of the worst bear markets in equities in recent history, they offer an unadulterated performance test for investors. Perhaps somewhat surprisingly, performance has been very consistent across all maturities, a low of 1.7 percent annualized on five years for the 2006 (maturity date) fund and a high of 3.2 percent over five years for the 2021 fund.

More recently, however, in the strong bull market in equities, the longer-dated funds are showing much stronger performance. For example, the longest-dated 2035 fund gained 23.8 percent over one year. In contrast, the 2006 fund gained only 1.3 percent over the past year. In this case, the equity portfolio has outperformed the defensive bond portfolio, which is a reasonable result given the times to maturity

But the conservative nature of the “lock in” funds is best demonstrated by the one-year return of the 2020 portfolio. It gained 14.3 percent vis-à-vis the 23.8 percent gain of the 2035 portfolio. That is a significant degree of undeperformance for a portfolio that will not mature for another 14 years. In this case, the Target Click portfolio is overly conservative given the investment time horizon.

Since capital moves in only one direction—from stocks to bonds— for lock in funds, the performance of the mid-dated funds will continue to lag the performance of the longer dated funds, assuming that markets appreciate over the long term.

While it is true that individual country stock markets have lost money over the more than a decade, Japan comes to mind, this risk can be minimized by diversifying assets across many markets and sectors. And that strategy greatly reduces the value of a lock in fund over time horizons greater than ten years.