The argument continues to rage about what, if anything, structured funds offer investors. Why do these products leave intermediaries so polarised?
When it comes to structured products, independent financial advisers typically fall into one of two camps - those for and those against. While you could easily argue both sides, what is clear is that in today"s regulatory environment there is a need for investment advisers to understand and monitor the array of structured products that are on offer. This in itself is not a simple task.
According to www.structuredretailproducts.com, in the opening month of 2004 the UK has seen a steady stream of product issuance comparable in number to the final period of 2003. In total, 43 products were noted in January against 43 and 45 in the last two months of 2003.
For many investment advisers, the case against structured capital at-risk products is a view that their client"s needs are best met by designing a balanced portfolio of assets, which are tailored to a particular risk/return profile. They will also argue that structured products are complex, opaque and offer poor value for money.
The opposing camp will, with some justification, counter that the financial instruments used to deliver a particular strategy within a structured product would not ordinarily be available to private investors. Also, it will be pointed out that clients, many of whom are still scarred by the global decline in equity markets which greeted the millennium, want a level of capital protection embedded in their investment.
Structured products do have a role to play, although within the product range available there are, like the wild west, the good, the bad and the ugly.
Structured products provide an exciting opportunity to build innovative solutions to meet the needs of some (but definitely not all) investors. My personal top five characteristics of the structured product market are:
1) An institutional product for the retail market
Few individual investors have the time or inclination to construct an investment portfolio that provides equity exposure but with a built-in level of capital protection. Structured products typically use financial instruments more commonly used within the institutional investment arena to deliver a variety of different investments solutions at a price that leverages the economies of scale from pooling investors" subscriptions.
2) The protected tracker
In 2003, a number of protected tracker products were launched that offered exposure to the upside of any growth while limiting the downside. Insight launched the Investment Growth Plan with a protected growth option that provided unlimited upside to the growth in the FTSE and a return of capital even if the FTSE fell at the end of the term. Feedback from clients and advisers was positive and this option outsold an accelerated growth option by two to one.
3) Clarity of return
A client considering a simple, well-designed structured product will have little difficulty understanding what the pay-off profile of the product will be based on different scenarios - a market growing, falling or staying flat. In assessing the return, the client does not need to factor in deduction of a preliminary sales charge or annual charges as this will be taken in to account when showing the potential outcomes.
4) An additional financial planning tool
As structured products are increasingly accepted as a part of the range of financial planning tools for investment advisers, there are signs advisers are seeing new ways to use structured products for retirement and other purposes. Insight"s own experience points to the use of structured products for retirement planning via Sipps and Ssas where investors want to participate in the stock market but are nervous that a fall could diminish their retirement pot at a time they need to secure their income.
5) New developments
The structured product market will continue to offer opportunities to innovate and there are some key developments that should continue to stimulate this market. In November 2002, the FSA adopted the Ucits Product Directive which reforms the regulation of collective investment schemes to allow a greater range of fund types, including guaranteed and limited issue funds. This environment should facilitate the development of a new range of capital protected funds and has received a further boost with confirmation by the Treasury that, from a tax perspective, all Ucits funds will be qualifying investments for ISAs.
the bad and the uglY
While many new products are addressing concerns about product design, it is interesting to pick out the ugly terms that still persist and which have the ability to upset unsuspecting clients. The features listed below are not necessarily inherently bad, but advisers need to understand why they are used in product design and what the implications are for their clients.
1) Geared downside risk (or loss accelerator)
This feature involves complexity beyond the understanding of most clients but with the potential to diminish their returns beyond any reasonable expectation of a 'capital protected" product.
Effectively downside gearing means that if the index (to which the performance of the plan is linked) falls to a specified level, then instead of the client losing money on a one-for-one basis, the client"s losses could be double or treble. For example, a product may feature 2x gearing on the downside, so if the index fell by 50% and stayed at that level then the return to the client will be nil.
2) Counter-party risk
Product providers will often purchase the underlying instruments that support structured products from a financial institution such as an investment bank. If, for any reason a counter-party fails to honour their commitment then the provider will not be able to give the returns promised within the terms of the product. So the credit risk of the counter-party is passed to the investor.
It is a dilemma for a product provider whether to deal with a highly rated counter-party where one hopes this risk is negligible or to move down the credit ratings to a bank which will offer better financial terms, albeit it increasing the risk to the investor.
In the UK, there are now clear rules governing the use of the word guaranteed in structured products. An IFA can be confident that any new products described as guaranteed will have the comfort of a third party guarantee or appropriate insurance cover.
3) Working out the average
This is not widely understood and tends to be ignored at the point of sale, which can be damaging if the final payout does not match the investor"s expectation. 'Averaging" is a mechanism that can arguably be to the benefit of investors when the market suddenly falls at the end of the term.
This is because the price used to calculate the final pay out will look back at the closing level for a specific period and average this level to determine the actual return. However, if the market does the reverse and rises sharply, this will have the effect of lowering the payout, which can lead to confusion and dissatisfaction. If explained at outset it should not be a barrier to the sale.
4) What a fix
The marketing literature for many products will normally make it clear that a structured product is for a fixed term of, say, five years and that clients should only invest if they are comfortable that they will not need to access their money during this period. This will suit some clients and not others.
My gripe is not with fixed-term products per se but the fact that the maturity payout may take place up to two months from the close of the index level which determines the final payout. This will no doubt be mentioned in the product literature and for the product provider the interest earned on the proceeds of a reasonable tranche is attractive, however, clients may not be too happy.
5) Complicating matters
Insight"s research amongst intermediaries continually confirms the need to design simple products which have a payoff profile that is easy to understand and can be presented in a balanced way with both the benefits and the risks clearly explained.
In the UK, one only has to review current marketing literature to see it is still not uncommon for the emphasis to be on a headline grabbing return. The FSA have taken a keen interest in the design and marketing of structured products due to the concerns over maturing precipice bonds.
More often than not a prominently featured return can be difficult to understand. To illustrate this point lets consider a cliquet-type structure (where the return is based on the sum of the rise in an underlying market over sub-periods within the product term typically with a cap on the maximum return in each sub-period). If we assume a headline rate promises up to 50% growth, the reality is that with this structure the return payoff profile may vary from a simple return of capital to a maximum of 150% growth. However, this is dependent on the underlying index rising within each of the specific periods and, if it falls in the first period, the maximum return will be limited to 140% regardless of where the index finishes at the end of the term.
Whatever your own personal likes and dislikes about structured products, we must learn lessons from the past and apply them to the design of new structured investment products.
Structured products provide an opportunity to build innovative solutions to meet the needs of some investors.
There is a commonly-held belief that structured products are too complex, opaque and offer poor value for money.
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