Unless you have been asleep under a rock (hopefully not a Northern Rock), you will not be surprised to hear that these are unprecedented times for financial markets. Global financial markets have been terrifyingly volatile over the past couple of months. Institutional and retail investors alike have been reducing their exposure to risky assets in their droves. Despite major stockmarkets having staged a bounce from an extreme bout of selling, their losses for the year remain appalling.
The sheer volatility of markets, with hundred-point daily swings common, has led to many cautious investors cashing in their equity investments, hoping to find shelter in lower-risk asset classes. But deciding where to reinvest hasn't been easy. With commercial property in the doldrums, and the corporate bond sector still relatively shaky, investors in search of attractive returns for not too much additional risk have been left with few options.
In this climate, surely investors would value an investment that offers a known level of capital protection, with the potential to participate in any gains on the upside? Well, structured investments can offer this; and yet the structured investment industry still has many detractors. This criticism is not new, yet they are often based on misconceptions or misunderstandings. This article tackles these objections head-on, to stress that, actually, now is the very time that investors should be using them within their portfolios.
Objection: This is not the time for investors to take on added exposure to volatile markets.
Yes, it is true that markets are especially volatile; and market professionals expect prolonged uncertainty. The bear rally over the last week has perhaps softened the blow, but it's clear that the global problems remain and the markets are still sensitive to bad news. All investable asset classes have suffered the effects of the global sell-off. Equities, bonds, commercial property and commodities have breached multi-year lows and investors have not been slow to relinquish positions in the riskier parts of their portfolios.
At Quantum Asset Management, we believe that these are just the conditions in which it makes sense to buy structured investments. These investments allow you to protect your capital and often to get equivalent or enhanced exposure to an underlying asset class, thereby maintaining your market exposure while reducing risk.
This highly volatile environment is also good for some structured investments, as they can be designed to use volatility to their advantage. Whereas a share price is linear (they can only move up or down), structured investments can be tailored to express a particular view. For example, if you believe markets will be volatile but range-bound, investments can be built that profit from both positive and negative market movements.
The other side of the coin is that now may well be the time to be increasing market exposure, if you take a medium term view. Investing using the structured route gives investors the confidence to enter the market when it is down, and return potential is greatest.
Objection: If my clients are looking for market exposure, mutual funds are an easier proposition to understand.
When you advise a client on long-only traditional equity fund, for example, your clients' capital is at risk and you are relying on the reputation or skill of the fund manager. You or your clients may not necessarily understand the entire workings of the fund, such as the model that the asset manager uses to select stocks, the extent of positions the fund takes, the asset selection, nor the possible shorting of stocks. Simply, your clients are trusting the manager to deliver against their mandate and investment brief, but have no idea what result to expect.
Structured investments, if properly marketed, are a much better proposition. The big difference between a traditional managed fund and a structured investment is that with a structured investment you know the basis of your return in advance and you know from the outset what risk you are assuming.
Objection: Structured investments are not risk-free and there have been instances where investors have lost a substantial part of their original investment.
This depends on the investment construction and investment proposition. In a 100% capital protected investment, the two main risks are:
- Opportunity cost - the loss of interest return on cash which would have been earned on deposit;
- Counterparty risk - the risk of default if the financial institution whose credit is used to protect the capital defaults on their loans.
The second point on this list has been a common criticism of structured investments in the aftermath of Lehman Brothers' collapse. Clients have quickly realised the possibility of banks failing is very real and investors have been keen to understand who the counterparties are that provide the capital protection and investment return.
In most cases, an investment's return and any capital protection is provided by the same financial institution. If the issuing bank were to default on its financial obligations neither investment return nor capital protection would be certain. By accepting protection from a lowly-rated institution, clients are unwittingly putting at risk the very feature of the investment that they most desire. We believe advisors will begin to scrutinise credit quality a lot more closely, and will only feel comfortable in recommending investments from providers who demonstrate clear risk management principles, and stick to them.
Objection: Structured investments are not suitable for clients who are looking for income rather than capital appreciation
Structured investments can be designed to deliver income, however they are not a direct substitute for cash accounts or annuity-style investments. However, as more people approach retirement, structured investments allow investors to retain exposure to riskier assets to maximise growth in their pension funds.
Objection: Investors can just as easily protect their portfolios by careful asset allocation and diversification and therefore do not need structures.
This may be true of some highly sophisticated investors, although it is worth pointing out that structured investments are used by institutional as well as retail investors. Many investors buy structures to get exposure to asset classes they cannot otherwise access such as commodities, credit, loans, hedge funds and emerging markets, such as China or India. Capital protection is especially important in these markets, where low or medium-risk investors want to limit the risks they take. It is worth noting that academic research has demonstrated that most institutional investors, except those with the highest risk profiles, can benefit from using structured investments.
Objection: Clients can easily create a structured investment style return through buying bonds and options.
Technically, this may be possible; but often it isn't. The reasons are:
•§ most people do not have access to buying options longer than 12 months ahead; so three, four or five year options are not available to individuals. In many instances it is not possible for individuals to create the same structures as the professionals because they do not have the same access to sophisticated investment instruments;
•§ professionals can get better pricing by aggregating demand, and being able to check the theoretical pricing themselves;
•§ professionals can wrap the instruments within legal structures that give advantageous tax treatment;
•§ professionals can give you access to markets where you cannot easily get derivatives, such as commodities, China, credit, and housing indices;
Most people recognise the benefits of specialisation in the modern economy. This is why we don't all build our own houses, grow our own vegetables, sew our own clothes or paint our own pictures - someone else can do it better and often cheaper too.
Objection: Structured investments are expensive and don't offer value for money.
Fact: Typically, structured investments are much cheaper than mutual funds. A retail structured investment will typically cost 6-7% of the initial capital, in total, for a five year investment. There are then no further costs or charges.
This compares favourably with holding a mutual fund for five years, where the typical costs are likely to be in the region of 9% (for a five year investment) once initial charges and the total expense of annual charges are taken into account.
Objection: Structured investments are too difficult for my clients to understand, and very often leave investor bamboozled.
In their simplest form, structured investments typically combine the purchase of a zero coupon bond (issued by a bank or financial institution) with an option. The zero coupon bond has a fixed interest rate whereby interest compounds over the investment period to return capital at maturity. The options provide exposure to an index or portfolio of stocks, providing the returns.
In a well designed structured investment, the investor proposition is usually very simple and clear to understand. Although the construction and pricing of the derivatives may be complex, this is not strictly the part that investors need to understand. Clearly, they should know what they are buying, how it will behave during its life and at maturity and what the risks are.
There is a dual level of responsibility here: firstly providers of structured investments must strive to ensure their investment propositions are clear. Secondly, clients and advisers need to understand the associated risks and return profile of structures they are investing in or promoting. Offerings with complicated arrangements and calculation mechanisms often have a risk or return profile that is not immediately apparent to the investor. Whenever the investment proposition is unclear, investors should ask questions or avoid altogether.
In the face of heightened market volatility and uncertainty, structured investments offer investors the possibility of simple, quantifiable market participation, often to asset classes that are usually hard to access. What is more, when considering structured investments for inclusion within a portfolio, it may surprise you to learn that over their lifetime, they have a lower total cost than a mutual fund equivalent. By understanding their benefits, structured investments are an area where an advisor can truly add value and compete on a direct level with private banks and large discretionary managers.
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