Absolutely. There has been, and continues to be, a lot of talk around this debate with not all parties in agreement on any one solution; traditional funds or structured products?
At Investec we believe that, in isolation, neither solution delivers the optimal risk/ reward balance. Structured products and traditional funds can and should be considered complementary to one another during the design stage of any portfolio which, in simple terms, allows the client to assess asset class returns in a variety of different ways whilst at the same time adding an element of capital protection.
Assessing Assets
Let’s get back to basics. Portfolio construction is about one thing; optimising a return profile for a client’s given level of risk, but not in that order. It is imperative that the client fully understands the risks involved with different asset classes at this stage to allow the adviser to build the appropriate asset weighted (note, not fund weighted) portfolio. There are essentially four main asset types; cash/ cash plus assets, equity assets, real assets, and alternative assets; all carrying different risk premia together with a variety of different return profiles. Note that I haven’t included structured products within this list. They are not a separate asset class but simply a means of accessing asset class returns in a different, sometimes more efficient way.
The adviser’s job, often with the help of a computerised modelling tool, is to balance the asset weighted portfolio against the clients assessed risk profile. Admittedly, this does sound complex however in simple terms a clients risk profile is a measure of how much capital they are prepared to lose over a given period of time. Not, as many understand it, where the client fits on a scale of one to ten, where one is cash and ten may be emerging market equity for example.
Getting the weight right
Once this process is complete, the adviser should have an appropriately weighted asset portfolio from which he can work out the expected returns over the medium term. Let’s assume for the purposes of this short article that the client has been deemed a “cautious” investor with an asset mix of 60% cash or cash plus assets and 40% equity assets. For the equity assets I am going to refer to UK equity for three main reasons. First, the FTSE 100/ All Share Indices are widely recognised by most advisers, allowing the assets to be more easily explained to clients and second, the UK’s top 100 listed companies derive more than two thirds of their profits from overseas and therefore form a reasonable proxy on which to base Equity returns. Lastly, the effects of globalisation now mean that global equity assets are, in the main, positively correlated meaning that geographical equity may not add much to a portfolio other than additional costs.
The benchmark return
I could now talk through how structured products could be utilised across the entire portfolio however I would like to focus only on the 40% equity element. For the adviser’s part, he has to firstly consider a benchmark return before actively picking funds/ products to meet and or exceed that given benchmark. This is an important part of the process but unfortunately very often gets lost in the hype of individual fund selection. At this stage we have only dealt with asset classes so the benchmark return should be set alongside the asset class. In this case, UK equity with an annualised return of 8-10% would seem appropriate. Equity return is comprised of three component parts, future dividend streams, inflation and equity-risk premium. So in this case 8-10% per annum would seem reasonable. In any event, whatever benchmark is chosen, the adviser and client should be comfortable that it represents a fair expectation from the asset class.
Fund/product selection
Now comes the difficult part, fund/ product selection; tracker funds, exchange traded funds, absolute return funds, the list goes on. However, with the majority of these fund types the client is taking on full market risk which, given the portfolio is already risk weighted, doesn’t necessarily present a problem. So looking at the fund selection process from a different angle, by adding an element of capital protection to the equity portfolio (by utilising structured products) it should be possible to deliver the target/ benchmark return in a more efficient way.
Protected capital options
To help the adviser in this process Investec Structured Products offers three FTSE100 linked notes. The Protected Growth Plan delivers 100% FTSE100 upside with a 65% cap on maturity; capital is fully protected against market falls. The Geared Returns Plan delivers 10 x FTSE100 upside with a 95% cap on maturity; capital is protected provided the FTSE 100 doesn’t halve at any point during the investment term. If it does, capital will be eroded on a one-for-one basis. The Accelerated Growth Plan delivers 165% FTSE 100 upside with no cap on maturity; capital is at risk on a one-for-one basis. By combining these Plans together in a sensible way, it may be possible to deliver a return profile to match or outperform the equity benchmark already set by the adviser and client. Or because some of the client’s capital is now protected, it may also be possible to increase the equity weighting of the portfolio without increasing the overall risk mandate, thus optimising the return profile for a given level of risk. In other words, efficient portfolio construction. So has the question been answered? I think it just has.
Gary Dale is Head of Intermediary Sales at Investec Structured Products.
