While the principle of risking capital for higher returns is well established, it is fundamentally important that investors understand the level of risk they are taking
The principle of investors taking a risk with their capital in order to achieve higher returns is perfectly acceptable, even to the FSA. What is fundamentally important for regulator, adviser and client alike, however, is that the level of risk is understood. In other words, investors should have a pretty good idea of how much income they will receive and what will happen to their capital. Broadly speaking, there are two ways investors are paid income:
• Genuine, ungeared income in the form of bank deposits, dividends paid from shares, or coupons paid from corporate bonds, or other debt instruments.
• Regular payments from investments, which may be generated from dividends, coupons, capital growth, option premiums, or combinations of these things.
Guaranteed income bonds are extremely simple and particularly attractive to cautious higher rate taxpayers. Returns are generated from underlying investments in gilts and low risk corporate bonds, the risk of any default being taken by the insurance company.
With net income levels of around 4%-4.5% however, there is limited appeal for the mass market and the majority of sales are generated by private banks and accountants. In spite of most investors missing the point of returns being paid net of tax, these bonds (offering fixed returns for fixed periods) are very easy to understand.
With-profit bonds have proved enduringly popular with investors. Essentially, the investor is totally reliant on the insurance company for the returns paid. With company reserves dwindling and equity markets set for a sustained period of modest growth, bonus rates of 4% or less could be the norm. In summary, this is a product investors do not understand, paying low income that is totally untransparent.
Equity income funds are designed to pay an income to investors, made up of dividend payments from companies. The principle is straightforward, with the aim that income will grow in line with the underlying capital growth in the shares.
With recent taxation-inspired falls in dividend yields however, these have become more difficult to market. Recent stock market falls and prospects for lower growth have not made these products any more attractive, although yields as a percentage of the underlying stock price will have risen.
These products have traditionally been popular in times of higher inflation and higher stock market growth with rising dividends (in cash terms) maintaining the buying power of income paid.
These funds need to be sold with advice and because of the variable nature of income payments and capital, have lost their appeal for many investors, particularly in a low growth, low inflation environment. Such products tend to be attractive over the longer-term as investors have historically enjoyed rising income and capital growth.
Split capital investment trusts have been around for a while and were originally designed for investors to receive returns taxed as capital growth rather than income. This was simply for reasons of tax arbitrage ' investors paid less tax for growth than income. This market has developed considerably in recent years, with trusts borrowing money to gear up investment returns. In a high growth environment, this works wonders.
These products can be difficult to understand and income payments can vary ' sometimes wildly. Recent adverse publicity has not endeared the investing public to this sector either and due to the illiquidity of the market, prices can fluctuate considerably.
With corporate bond funds, investors are effectively loaning money to different companies and receiving interest income for doing so. The greater the risk of a company defaulting on interest payments, the higher the interest rate.
At the bottom end of the scale, most governments will issue debt and the risk of non-payment is very low (they can always tax the population). This is reflected in the low coupons (interest) paid on gilts for example, which yield between 4% and 5% depending how long it is until capital repayment is due.
Most investors will have a grasp of how corporate bonds work, but it is not always so clear how much income they will receive and what their capital return will be, so they generally need help from an adviser.
Structured products are so called because they are capable of structuring or shaping the risk/income profile of different types of assets through a combination of fixed interest instruments and derivatives. High income structured products pay a relatively high fixed stream of income but increase the risk profile. Lower income products still pay above average income but can afford to reduce the associated risk. The key difference is that through understanding a set of conditions, the investors can rely on a fixed series of income payments and understand exactly what they will get back for the whole range of investment outcomes.
These products do not break the risk/reward relationship but what they can do is crystallise it into a clear and unambiguous proposition. In uncertain times, investors appreciate the certainty of knowing they will have a fixed income for a fixed period of time and being fully aware of what will happen to their capital.
Because structured income products offer the attractions of fixed income and a clear capital return, they are very popular with investors and advisers alike. But recent developments in the market have led to a complexity in product design, which means that investors are buying products with inappropriate and misunderstood levels of risk.
Ignoring the effect of implicit charges in these products, there are three key components affecting the risk/reward profile for investors: the underlying investment link, the term of the investment and the payment profile.
The table above shows a simple measure of historic volatility, which is seen by many as a level of risk, or the likelihood of the underlying investment to move/fall to a greater or lesser extent.
The FTSE 100 index is seen as the preferred investment link not just because of its lower volatility but also because it is an appropriate first step for investors new to equity markets.
Established in 1984 and measuring the UK's 100 biggest companies, it is well known to investors and advisers alike. Because it is an index, poor performing stocks will fall out, without continuing to drag it down as their share prices go into freefall.
The Eurostoxx 50 is an interesting choice as an investment link for cautious investors. It was established in 1998 (although it has been recalculated to 1991) and measures the fortunes of the eurozone's largest 50 companies ' so no exposure to UK companies at all.
The fact there are fewer stocks in the index and a heavy weighting towards European telecoms companies are the prime drivers behind its higher volatility.
It would not be an obvious choice for most investors to invest in Europe (ex UK) funds as their first foray into stock market linked investment.
The Eurostoxx 50 is popular because it allows product providers to pay higher income and take a wider profit margin. Whether it is an appropriate link for the investors who buy structured products is open to discussion.
The top 10 FTSE Shares is another interesting choice for an investment link. It does provide investors with a link to companies they may have heard of, but linking to individual shares, rather than an index has implicitly greater risks attached.
The benefit of an index is that the rubbish drops out but if you are linked to single shares, you follow them all the way down.
It is interesting to note that previous products have been linked to single shares, some of which have fallen spectacularly (Marconi, Colt Telecom for example). Again, the analogy to consider is whether a cautious investor's first foray into the stock market would be an investment in 10 individual shares.
As for investments term, looking back three years from now, stock markets were riding around 20%-30% higher than they are now ' so if investors had their capital return linked to a three-year market view, they would be pretty disappointed now. Even after recent stock market falls, a five-year term would have allowed for a full return of capital.
So if a client says they do not want to tie their money up for more than three years, it is worth reminding them of the risks associated with stock market linked investment over such a short period of time.
With UK base rates at 4%, returns of 10% do not come without significant risks attached. When these products first became popular in 1996/97, base rates were significantly higher, so 10% was achievable at less risk to capital. In today's environment, even 7% a year, particularly tax free, is a very attractive level of income to investors.
The income level on structured products vary, but so too do the various risk reduction and yield enhancement features on offer.
Safety nets are almost universal now and it is worth bearing in mind the current starting point of the underlying investment links. For the FTSE to fall 25% from current levels, it would be quite a bit below 4000 points. This would cause problems throughout the investment industry (imagine the effect on life company reserves) and would be big national news.
Final index measurement has almost universally moved to using the worst level in last six weeks feature. Although this increases the risk slightly, the benefits in terms of higher income paid to investors are seen as very worthwhile, particularly on five-year products.
Extra months tagged on to the end of investment terms provide a marketing benefit, in other words the rate on the cover of the brochure is higher than the overall rate for the investment term.
In a low inflation environment, many investors are looking for security of income in cash terms, and are not too worried about maintaining their buying power. What structured income products offer is the security of knowing how much an investor will receive as income, and, just as importantly, exactly what their capital return will be under different circumstances.
The most important features of these products are the investment term (five years is better than three) and the underlying investment link, which should be appropriate and easily understood and monitored by the client.
Risking capital for higher returns is an accepted practice but a suitable risk/reward balance must be adopted.
Structured products are so-called because they can shape risk/income profile of different assets underlying investment link, term of investment and payment profile.
Three factors affect the risk-reward profile for structured income products.
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