Much of the adviser community remains wary of structured products, often seeing them as complex vehicles that gamble on indices not losing a set percentage over the 5-6 year investment period. David Burrows looks at how these products are structured, the criticisms that advisers raise, providers' response to those criticisms and how the new wave of products can fit within a client's portfolio.
It has not been a pleasant spectacle to watch global stock markets over the last year or so. After climbing above 6,750 in July 2007, the FTSE 100 index has since slumped to its present position below 5,300 in July 2008. No doubt it will continue to experience short term rallies but in the main the trend is downwards and perhaps more importantly investor sentiment is positively subterranean.
The recent volatility in the markets, not surprisingly, has led investors to look at more cautious investments and more particularly investments that offer quantifiable safeguards in regard to return of capital. Other ports of call for investors looking to diversify and spread risk have effectively been closed off – the property market is as depressed as the stock market and corporate bonds have limited appeal too. In a climate such as this investment vehicles such as structured products arguably come into their own.
Cynics might suggest that market conditions have played into the hands of structured products which offer various capital protection or guarantees but which limit the upside. One of the common criticisms of structured products is that they are too complex and IFAs are in the vulnerable position of selling a product of which clients have only a sketchy understanding.
The basic concept is quite straightforward as the structured product provider assures to pay back to clients a defined percentage of their initial investment if stock markets fall, as well as a set amount of the gains if markets rise. Of course, the make up of the products itself is a little more difficult to understand and there have been concerns about the definition of ‘guarantee’ as well.
In addition, until recently structured products had no meaningful track record in terms of performance figures to point to. That is beginning to change now; whilst not a mature market, structured products enjoy far more awareness now in the IFA market and by definition they will attract more attention when downside protection is in vogue as opposed to in the middle of a bull market.
Kim Barrett, IFA with Bishop’s Stortford-based Barrett & Associates, believes advisers remain wary of structured products. “I agree the basic concept is quite straightforward but there are so many variations on the theme that in effect it becomes pretty complex.” As a case in point Barrett points to a recent product launch which is linked to the fortunes of five banking stocks and which offers investors 1,250 per cent exposure to their returns. This means that, over the next five years, the portfolio of banks needs only to grow by 10 per cent for investors to get a return of 125 per cent. Although there's also a capital guarantee, the downside is that if one of the bank stocks falls by more than 50 per cent during the period, investors stand to lose more than half of their money.
“I thought this product was interesting and in theory I could say to a client my belief about banking stocks is this, this and this but at the end of the day it is still a punt. I am not averse to structured products but I think there is a danger that in the present climate some IFAs are going to use them as an alternative to cash because of the commission on offer.”
The trade off with structured products is that just as your downside is limited – so, typically, is your upside. There is also the fact that structured products do not pay any dividends. That said many of the more sophisticated products offer to lock in any gains each year, while the gearing element of structured products can also help to generate strong returns that will make up for any loss in the dividend.
Where do these products sit in a portfolio? Some advisers believe that there really is no place for these structured products in a regular portfolio. Graeme Mitchell, IFA with Galashiels-based Lowland Financial, does not dismiss structured products out of hand but he has yet to be convinced of their merits. “I am a little bit concerned about the layers of costs – you have admin costs, fund costs, advice costs and also the added cost of the guarantee - you have to weigh that up against getting 4pc net from a building society.”
He adds: “I would like to have more access to structured products on the platforms, I am interested in seeing what comes to market but so far nobody has pressed the button that has switched me on to these vehicles yet. I think providers have to prove the benefits to clients and justify the extra costs – the first signs of performance track records are certainly going to help. As things stand, for a lot of IFAs, if a client wants to take risk then go into the market; if they don’t then go into cash – all the time being aware that cash has its own risks.”
Bad taste in the mouth Mitchell concedes that, undeniably there is still a degree of reticence from IFAs towards structured products following on from the precipice bond scandal – perhaps the association is an unfair one but he insists it still plays a part. “It is a bit like when you are bitten by a dog as a child, it leaves a big impression. Precipice bonds seven years ago saw maturity values not coming up to scratch, income was taken from capital and then we had the big hangover in the shape of PI insurance. With clients free to complain for up to seven years on precipice bonds, we had a ₤25,000 excess on our PI insurance, so you could say it left an impression! I don’t think this means that myself and other IFAs won’t look at structured products it is just another factor which adds to a general wariness”
So what about this idea of guarantees, isn’t that something that investors want in this current climate? “I think you could justifiably argue that structured products are at their most attractive when a market fall is anticipated but I think now you could say it is too late – the market is pretty much at rock bottom, do you really need guarantees now? I think to a large extent you have missed the boat – though as a sceptic of the product I am not sure the boat was there in the first place.”
We have heard some of the reservations from IFAs towards structured products but what is the other side of the story from providers? How difficult is it to convince advisers of the merits of structured products? Gary Dale, head of intermediary sales, at Investec Capital Markets gives the case for the defence. “It is a challenge to convince IFAs of the merits of structured products. A lot of progress has been made – this year we will see ₤7.8bn in structured products and over the next three years we should see that figure rise to ₤10bn-₤12bn. But when you compare that to the ₤46bn that goes just into collective UK equity funds, you see that this market has a long way to go.”
Dale agrees that to a degree IFAs can be put off by the sheer number and types of structured products brought to market but he insists IFAs can make life a bit easier for themselves. “With so many launches, the idea of IFAs researching every structured product is pure madness but the likes of FVC do provide independent views and will rate all products – providing risk maps and value scores.”
He adds: “I think there is a huge education issue for IFAs on structured products and I would agree that the precipice bonds scandal did have a negative effect. I don’t think IFAs will switch on again until they understand how structured products work. But what I think is crucial is for advisers to understand that ‘risk’ is different from product to product. There is huge value to be had now in buying structured equity funds rather than collectives however I would argue that a structured product can be seen as a complement to collectives rather than replace them.”
On the claims of excessive charging, Dale maintains that structured products are competitively priced. “Unlike hedge funds there are no performance fees, the charges are transparent, there are no bid offer spreads. At the end period there is a pay off with averaging smoothing out index volatility – it can be a bad thing if the FTSE spikes and then falls off but the whole point of structured products is to smooth out the troughs of the market.”
As for complex products, for instance commodity-based vehicles, Dale insists there is an appetite but it is not in the retail space. “There is a place for racier products within the institutional market but for retail investors it is about simple products.” As things stand however, Dale suggests there are enough variations of ‘simple products’ to keep IFAs on their toes. “The whole issue of guarantees is misleading – some products do have special guarantees but others increase the upside but have no limit on the downside. For instance there are plans that offer 170pc of any upside on the FTSE but there are no guarantees. Given that IFAs do have research facilities like FVC, I don’t think it is a bad thing that there is a wide degree of choice out there to suit different risk profiles.”
As for the idea that the best time for guarantees has passed, Dale is having none of it. “Volatility is still incredibly high and the market may be up and down for a long time. If an IFA decides a client needs to be in UK equities, buying the market is not the only place to be, it might prove far more efficient to be in a structured equity product. You can chase 20-25pc per annum but you have to be in the market to make the return but why not be in a geared fund? It is not just about selling a guarantee it is also about accessing an asset class in an efficient way. At some point it will be inefficient to go into a structured product but this is not the case at the moment – there is a very strong case for using structured products in the current market.”
In May this year Investec entered into the structured product market, Dale insists the proposition is a strong one. “We have unveiled four categories: Accumulation, Investment, Income and Structured. The risk profile increases as you go up the scale from Accumulation for those who are risk averse right up to the Structured fund (likely to launch in October) which will be an open-ended product using derivatives. We have got the resources and the team to ensure these funds are well run and well serviced and we are very excited for the future.”
How do Structured Products work? Most structured products work by investing the majority of a client's money into a bond or cash deposit account, which will grow by enough to cover the capital guarantee once the product matures. For example, if you were to invest in a five-year guaranteed equity bond, the provider might invest about 75 per cent of your money in an A-rated bond, paying just under 5 per cent interest per year. By the end of the five years, this bond would have built the 75 per cent back up to the full value of your initial investment.
The manager would then use the remaining 25 per cent of your investment to try to generate an additional return. Through the derivative markets, the managers can leverage their position – meaning that they need only to invest a small amount to get a large exposure to an index or stock.
This feature was first published by our sister title Professional Adviser.
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