While attractive participation rates can be alluring, it is important to gather all the information necessary before choosing a structured product and to identify the advantages of one product over another
The demand for structured products continues to grow as well as the variety of methods for offering investors attractive returns. This has lead to a proliferation of products, but also a growing level of complexity within those products, making it increasingly difficult to understand what each different structured product is offering.
In their simplest form, the aims of the majority of investors looking to invest in a structured product are clear: to benefit from exposure to equity gains, while being protected from capital erosion due to large equity falls. Unfortunately, there is no such thing as a free lunch, and the peace of mind in knowing that your initial investment is not at risk must be paid for. Again, in its simplest form, the cost of this peace of mind is foregoing the income yield on the equity investment (currently about 3.5%) and having your money tied up for a number of years.
But in the current low interest rate environment, the simplest structured products are not delivering high participation rates. The term 'participation rate' is generally used to refer to the percentage of the capital growth of the underlying index that the product will pay out if the index is higher at the end of the product term than the beginning. For example, if a product is offering 95% participation in the FTSE 100, and the FTSE 100 grows by 30% during the term of the product, the investor will receive a return of 28.5% on their initial investment.
Recent events have meant that demand for structured products has never been higher: investors remember the high returns delivered by equities during the 1990s and would like to have a share in that, but they also remember the pain of the 2000s, and want their investment to be protected. Product providers are clearly keen to meet this demand, and the structured products marketplace has become increasingly crowded. However, the current low interest rate environment is not particularly conducive to delivering high participation rates through simple structured product design, and providers are developing increasingly complex investment strategies to support a competitive and attention-grabbing headline participation rate.
Choosing a product
With this high volume of products, it has become increasingly difficult for investors and advisors to identify the advantages of one product over another, and naturally the participation rate is an easy indicator of quality and suitability to fall back on. But if we ignore this feature for now, what are the other features an investor should look for when choosing a structured product?
The first point to be clear on is what are the investment objectives of the investor. In that context, the following factors should be considered:
• What is the product wrapper? Is it suitable for the tax situation and objectives of the investor?
• How long will the investor's money be tied up for? (Note that some products will allow redemption at any point during the term of the product - but without any promise of capital protection - and others will not allow redemption by the investor before the end of the term.)
• What index is the product linked to?
These are the primary considerations. Once a shortlist of products has been selected - that are suitable on these counts - the following factors can then be taken into account:
• Does the underlying index have to be at a certain level before the investor is certain to receive at least their initial capital back?
• Is the return of initial capital guaranteed? If so, who is the guarantor?
• Is the return of initial capital protected? If so, under what circumstances might initial capital not be returned?
• Are there circumstances under which the investment may be terminated early by the product provider?
• Does the investor understand how their money is being invested?
In some circumstances, it is not always easy, particularly for the average investor, to gather all the information necessary to answer these questions, and the participation rate offered is an alluring distraction. Some product structures provide exceptional participation rates - perhaps twice the capital growth of the underlying index (up to a certain limit) - but have complex 'triggers' that must be met before these rates will be paid out.
Such products, often termed 'dynamic growth', are growing in popularity with providers. Typically, the final return achieved is dependent on the underlying index having achieved a certain growth level at the end of the product term. However, there is usually a test at the end of each year of the product term, and if a predetermined growth level has been reached by that stage, the product matures and full repayment of capital, together with the return achieved, is paid to the investor.
The chances of the index reaching the growth level set for the end of term, in which scenario the product pays out spectacularly, may seem reasonable, but statistically the chances of it reaching that growth level without hitting any of the other triggers during the term of the product must be much lower. While the headline participation rate under this structure looks very appealing, it is important the investor understands the likelihood of receiving that payout compared to other products with lower participation rates but no early redemption triggers. In addition, the investor has to be happy with the uncertainty of the term of the product being out of their control.
Another methodology increasing in popularity is the revival of portfolio insurance. This has been around for some time, but its sophistication has increased dramatically in recent years. In portfolio insurance structures, the investment manager invests the assets in a mix of risk-free and risky assets (the underlying index to which participation is linked). The optimum amount to be invested in the index is a factor of by how much the total value of the portfolio at each point in time exceeds the net present value of the guarantees provided at that point. The level of excess required is a factor of by how much the investment manager estimates the value of the index could fall in any one day, based on historical experience.
The investment manager monitors the split of assets invested in both the index and risk-free assets every day, and uses dynamic modelling to ascertain the optimum split of assets to achieve the highest return but avoids locking the fund into cash. When the difference between the actual investment in the index and the optimum exposure exceeds a set level, the portfolio is rebalanced.
keeping hold of returns
Earlier versions of this methodology suffered from inaccurate assessments of the maximum possible daily falls in the underlying index. Some products found all their assets were 100% invested in cash very early on in the term of the product, and effectively locked into cash from that point on, leading to disappointing payouts for investors despite subsequent increases in the underlying indices. Recent versions have learnt from these mistakes - some initial participation in the risky assets can be foregone to enable the floor to be set higher than 0% and prevent the fund ever being locked into cash.
In addition, lock-in features are now common, meaning that returns earned cannot later be lost. These products offered a guaranteed minimum level of return over the life of the product and a clear cap on the upside that can be achieved. Therefore, on the face of it, these products offer a simple and easy to understand upside and downside. But the achievement of the product terms is dependent on the successful operation of the underlying technology and the robustness of the assumptions underlying that technology. These details are complex and make it difficult for the investor to understand how their money is being invested, leading to reliance on the participation rate as the indicator of product suitability.
The concept of what these products are aiming to provide is simple - exposure to the upside of the equity markets without putting capital at risk - but the investment techniques underlying the concept are increasingly complex. The recommendations of the Sandler review introduce the danger that we may be entering a stage of the savings lifecycle where products based on complex technology are sidelined in favour of those that are simple and easy to understand, even if they do not meet their investment aims as well. To mitigate this danger, it is incumbent on all involved in the development and sales of structured products to ensure that technology is used responsibly to really deliver the products that meet investors' needs.
Investors remember the high returns delivered by equities during the 1990s, but also remember the pain of the 2000s, and want their investment to be protected.
Unfortunately, there is no such thing as a free lunch, and the peace of mind in knowing that your initial investment is not at risk must be paid for.
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