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A winning strategy

Created:

22 June 2009

Written by:

Glenn Martin

When you've got a strong view about where the markets are heading, accelerated trackers are a great way of turning your belief into big profits. The most successful investors are those whose views about the market are formed by following simple but effective rules-based systems. Using a system takes the emotion out of investing, helping you to enter and exit your positions at logical moments.

One system that has an excellent record of telling investors when to get in and out of UK equities is the ShareMaestro program.

This computer package calculates what the FTSE 100 is worth today and what it will be worth in five years' time. It does so by looking at dividend growth, risk premia and forecast inflation rates – see 'What is ShareMaestro' below.

Because it looks specifically at a five-year investment horizon, ShareMaestro is an obvious tool to use when looking at a FTSE accelerated tracker that runs over the same period. To see ShareMaestro in action, let's employ it to assess the investment potential of RBS's UK Accelerated Tracker, which was issued this April and expires in April 2014.

The outlook for UK shares

When considering the UK Accelerated Tracker, you should ask yourself the following key questions:

■ Where do you think the FTSE 100's price will be on 28 April 2014?

■ What's the margin of error in your forecast?

■ Given where you think it'll be, how would the accelerated tracker's returns compare with what you'd get by investing in the FTSE via another product?

■ Could the FTSE fall by more than 40 per cent from the price when the tracker was issued?

ShareMaestro can provide an answer to each of these. First, let's think about where the FTSE is likely to be five years from now. In order to do this, we have to key in some basic assumptions about the future. The package's default setting is for dividend growth after inflation of 2 per cent a year. Because of the recession, however, this isn't appropriate right now. The FTSE's historic dividend is already down by 11 per cent and City analysts believe it could fall by a further 30 per cent.

If this 30 per cent drop took place over the next year and then 2 per cent annual growth resumed, the real annual dividend growth rate over the five-year period would be 5.4 per cent. Keying this figure into ShareMaestro gives us a forecast for the FTSE in 2014 of 5223 – see the screenshot below for more details. That implies a total increase of 27.5 per cent over the period.

The UK Accelerated Tracker doubles all positive returns up to a limit of 90 per cent. So, a 27.5 per cent gain in the FTSE would translate into a 55 per cent return if you bought this product. This works out as a compound annual growth rate of 9.2 per cent, which is comfortably ahead of what you'd get from holding a typical five-year fixed-rate cash bond.

However, it is marginally less than the 9.3 per cent you might get from investing directly in the FTSE 100, assuming tax paid at the basic rate, because of the impact of income.

Neither the Accelerated Tracker's return nor the direct investment return from the FTSE 100 mentioned here take account of any capital gains tax (CGT) which may be payable. It is therefore essential to review your CGT position before making any investment decisions. You also need to take account of fund management fees if you intend to invest in the FTSE 100 via a fund – for example, an exchange-traded fund (ETF) or a tracker.

Allow a margin of error

One of the beauties of the ShareMaestro system is that you can experiment with lots of different scenarios. So, let's stress-test our five-year valuation of 5223. It is a fair bet that inflation and interest rates are now at rock bottom. One stress-test would be to consider the effects of inflation hitting 4 per cent by the end of our horizon. This would bring down ShareMaestro's projected valuation to 4922. Under this scenario, the tracker's compound annual return would be 7 per cent, lower than the 8.2 per cent you'd get from directly investing in the FTSE 100 and reinvesting dividends.

Optimistic or pessimistic

The UK Accelerated Tracker provides capital protection unless the index falls at any time by 40 per cent from its starting value, to 2458. ShareMaestro can also help to determine the risk of this occurring. The programme tells us that one way the FTSE could fall by this much is if inflation rose to a maximum of 7 per cent and the real dividend growth rate dropped to -15 per cent a year. That would imply a halving of UK nominal dividends over the next five years. Unless you believe in Armageddon, therefore, the message we can infer from ShareMaestro's calculation is that a drop to 2458 is unlikely.

Based on our core projection of 5223, we have already said that there is little difference between investing in the Accelerated Tracker or between buying into the FTSE directly. However, if our ShareMaestro forecast turns out to be conservative – which is entirely possible – the Accelerated Tracker's 200 per cent gearing would cause it to outperform direct investment in the index. As of the date of issue, then, the odds favoured buying the accelerated tracker rather than a plain-vanilla FTSE ETF or unit trust.

Buying accelerated trackers after issue

If you buy Accelerated Trackers on the open market rather than at the time they're issued, your potential returns will be different from buying at issue date. This is because you will be holding the investment for a shorter period and will be buying it at a different price. Also, the potential expiry price of the FTSE 100 is likely to have changed.

You can use ShareMaestro to assist your investment decision here, too. On 29 May 2009, the product's price had increased to £107.50, reflecting the increase in the FTSE 100 from 4096 at issue to 4418. You should also tweak your assumptions based on any updates on the inflation or dividend outlook.

A very slight change in the inflation outlook has increased the potential FTSE 100 expiry price marginally to 5227.2, an increase of 27.6 per cent. This increases the potential payout to £155.20. Calculating compound growth, you can see that the potential annual return has fallen to 7.75 per cent because of the extra price paid for the product.

Risk control

Although you may invest in accelerated trackers on a long-term basis, you can control your risks by performing regular ShareMaestro valuations on the FTSE 100. If, for example, ShareMaestro's valuation falls to 90 per cent of the index's actual price, the FTSE 100 is much more likely to fall than to rise. So, you may then decide to sell your tracker in the open market and then buy back in again if or when the FTSE 100 has fallen to a more realistic level.

Trading the FTSE 100 via accelerated trackers

You could also use accelerated trackers bought on the open market as a short-term trading vehicle, again guided by ShareMaestro's FTSE 100 valuations. Depending on your risk appetite, however, other securities may be more attractive for this purpose, such as ETFs, which give dividend income, or covered warrants, which do not provide dividend income but can provide much higher gearing.

What is ShareMaestro?

The ShareMaestro software system computes the intrinsic values of UK equities from the fundamental factors that determine those values. These factors include published market and economic data. You can also assess the impact on values of changes to these factors, either individually or in combination.

ShareMaestro comprises two modules, one to value the FTSE 100 and one to value individual shares. A new version of ShareMaestro has recently been released, which includes a bulk share-valuation facility (ie, all shares in the FTSE 100) with the facility to export results to a spreadsheet to enable users to conduct further research.

ShareMaestro has an excellent track record. For example, since the start of the FTSE 100 in 1984:

■ Every ShareMaestro buy signal has delivered a profit on the subsequent sell signal.

■ The average annual growth in the FTSE 100 has been 23 times greater during ShareMaestro's signalled investment periods than at other times.

■ A strategy using ShareMaestro's FTSE 100 investment signals and FTSE 100 covered warrants has delivered a market-leading compound return of 18.3 per cent annually over the past 25 years

In the FTSE's last big bear market, the index fell 53 per cent from a peak in 2000 of 6930 to a trough of 3287 on 12 March 2003. The ShareMaestro valuation given on this date was 4957, implying that the index's true value was 151 per cent of its price at this point. This did not require using any special insights about the outlook. The dividend, inflation and bond data is all publicly available, factual information. The assumption of a 10 per cent risk premium and 2 per cent real annual dividend growth was merely based on long-term historical averages.

The deep undervaluation in the FTSE flagged up by ShareMaestro in early 2003 proved prescient. Over the next four years, the index's price surged.

The valuation given in 2003 contained other information that would have been valuable for assessing the investment potential of accelerated trackers.

■ The projected value of the FTSE 100 for 12 March 2008 was 5441. This projection proved to be just 6 per cent below the actual level for this date (5776).

■ The projected annual investment growth rates, including reinvested dividends taxed at both basic- and higher-rate tax (shown in the image, above, as 1 and 2 respectively,). This information is critical in comparing the merits of investing in an accelerated tracker, which excludes dividends, with investing direct in the FTSE 100 (via, for example, ETF) where you will receive the benefit of dividends. These reinvested dividends can form a significant element of your overall investment return.

Visit www.sharemaestro.co.uk. A free trial is available.