Structured products are becoming ever more mainstream as investors seek lower-risk investments offering similar returns to equities, but it is important to use quality vehicles with clear structures to ascertain their true value
The structured product market has traditionally been a fairly esoteric investment area but is becoming more mainstream. Good quality, transparent products have a place in the diversified client portfolio both today and in the future.
We are roughly 1000 days into a bear market, the longest since the 1930s.
We take the view that the best a US investor can expect for the next few years is 8% per year from equities, 5% from bonds and 2% from cash. As long as inflation stays low, these low returns will be acceptable.
However, this means there is a strong case for finding or creating investments that give returns similar to the 8% for equities but without full market risk and exposure. We want to avoid the volatility.
Part of the answer might be structured products, and by that I mean mean only well structured, transparent and reliable products.
Structured products have been around for many years and encompass products many advisers may not automatically think of as structured. These are products such as with-profits and managed funds that, to one degree or another, provide a mix of cash, bonds and equities.
Structured derivative products are still relatively new but have grown exponentially in recent years. For those scared by the D word ' derivatives ' it should be emphasised that when building a structured derivative product, there are four basic considerations:
• Interest rates ' where are they now and where are they going?
• What volatility is there in equity markets?
• The life of the product.
• The cost of the instruments that go into it.
Only when all four of these factors are met will there be the right criteria for a product that meets investor expectations.
It is also wise to remember that with good structured products, the terms are set at the outset. The instruments inside the product are bought and there is no fiddling about along the way, so what you start with is what you finish with.
Structured products have got some things in common. They all broadly achieve the same result, which is a mix of risk and reward.
In general terms, a high-risk product simply means giving something that looks and feels like an equity investment. Medium and low-risk products should be more akin to investing in government bonds.
Structured derivatives can achieve suitable diversification to meet a variety of risk profiles depending on the investor choice. They are fairly straightforward and can be easily broken down into constituent parts.
The first is a capital protected structure that returns the investor's capital over the life of the product, giving exposure to the FTSE. We start by simply buying some purpose-made corporate bonds of high credit quality, typically issued by building societies with double-A ratings.
These pay interest. With that interest we buy a call option on the FTSE 100, which will give the upside participation as the market goes up. If the market goes down, the corporate bonds, assuming the building society does not go bust, will repay the capital parts.
If the market goes up, investors get their money back, assuming the credit risk is fine, and 90% of the rise of the FTSE 100. Nothing too opaque there.
Another way of looking at it is the type of product that seeks to provide a high income with significant market protection. Again, investors buy a bundle of corporate bonds of double-A quality. In this case, interest is generated by the bonds, but rather than buying call options, we sell at the money point options.
This means a bundle of options that kick in if, for example, the market falls 40% over the life of the product.
For selling these options, we get some premium combined with the bond and option premiums, which is the income returned to the investor. There are two possible outcomes: if the market hits the low point at any time during the life of the product, which might be three, five or seven years, all the income ceases and thereafter it is effectively an index tracker. If the market goes up, the value goes up, and if the index goes down, the market goes down.
If the 40% low point is not reached at any time in the life of the product, the investor gets his capital income. The most important aspect here is that whatever the outcome in the market, the investors will know what they are going to get.
Structured products should be uncomplicated, relatively low cost and transparent. It is important to understand what is inside a product so you can value it. Highly liquid as a lot of these instruments are, good ones will typically be listed on the stock exchange, so if it no longer suits an investor they are able to sell it. There aren't that many products in the market with those features, especially in this environment.
Is this an esoteric market? Well, last year more than £5bn was raised in products such as this and an amazing £30bn across Europe.
It is explosive again this year. The products typically fall into two categories: capital guarantee with some upside in the market, which can be on an index or a basket of stocks; and high income or a variation that seeks to give the return of the investor as capital gain.
But it can't be all good news. There is quite a lot of down side. It's fair to say in the past few years, some of these products have had very aggressive marketing, which has quite clearly over-promised and under-delivered.
A number of products have what I would term 'toxic risk profiles'. That simply means while a number of outcomes are possible, the worst-case outcome is that the investor ends up with much less capital than would have simply come about by investing in the underlying market and therefore investors end up with the worst of all worlds.
Part of the process with the aggressive marketing of high risk is that investors and intermediaries have to fully understand in what they are getting involved. Some of the structures available involve sophisticated mathematics and models which, frankly, I don't understand, so it's unreasonable to expect the investor to do so.
Another consideration is that it is counter-intuitive to invest in a product or a fund in which there is no price transparency, where you can't see the value of the assets and have little ability to exit the investment if it no longer meets investors' requirements.
This, again, has been an industry issue. Regrettably, there will be a number of products and guaranteed-type funds that reach maturity in the next year or two that will disappoint investors. We clearly have to hope there is not too much bad publicity for the industry.
It is essential to understand the risks involved and the impact they have on an investor's portfolio. There are undoubtedly good products and bad products, just like everything else in life.
In the bad ones, the risks are usually hidden in the small print ' we all know how the world works. It's worth going the extra mile to understand the risks clients are taking on.
I strongly believe good quality structured products are not just a function of their market and that when markets do eventually pick up, they will still be highly appropriate. They have a real role to play and will be an essential financial planning tool in the future. They will be a useful part of an investors portfolio for many years ahead.
Use only transparent structured products.
Structured product terms set at outset.
There are structured products for many risk/reward profiles.
Important that intermediaries understand a product to value it.
Seek out liquid, listed structured products.
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