It is wrong to think of structured products as an asset class in their own right, argues Nick Johal - they are simply investments that offer access to actual asset classes such as equities
‘Structured products' or ‘structured investments' are widely used terms that can usually be relied upon to provoke some sort of a reaction among advisers - generally a positive one for those who have used them for a number of years as part of a diversified portfolio but, if not, then just as likely a negative one.
Yet ‘structured products' is really a generic term and should not be thought of as an asset class. You cannot ‘like' or ‘dislike' a structured product - you can only like or dislike the risk and return profile it gives you. It should be thought of as a contract that delivers a return dependent on an underlying asset and this should ultimately determine where it sits in a client's portfolio.
The specific investments we are talking about here are linked to an underlying asset class, such as equities, and generate a defined return for a defined risk. In the UK, the most popular structured products of recent years are ‘autocalls' linked to an equity index such as the FTSE 100, and these investments simply access a return from equities in a different way.
In our view, autocalls offer the highest probability of generating a return after fees of 5%-plus a year. With a strong track record and high forward-looking probabilities of achieving their positive return, there is a strong argument for using autocalls within a diversified portfolio.
Autocalls - or ‘kick-out plans', as they are often known - deliver a defined equity-like return through capping the investor's exposure to an equity index and building a buffer of protection against the downside, thereby increasing the probability of said defined return.
Yields available currently range from 6% to 11% a year, depending on the risk an investor is willing to take. In addition, the investor usually has credit risk to a financial issuer of the securities - normally a global bank.
This is important as the returns are a contract between the investor and issuer who, subject to their solvency, must deliver the returns if pre-defined conditions are met. Those pre-defined conditions, in the example of a FTSE 100 autocall, are transparent and determined at the outset. The only decision for investors is whether they are happy with the return and the risk profile.
So saying you don't ‘like' structured products doesn't make intuitive sense. You can only dislike the risk/return profile an investment offers - after all, a FTSE100 autocall simply gives an investor an alternative way to generate an enhanced yield that is dependent on the performance of the index.
Investing directly in a FTSE 100 exchange-traded fund, for example, gives an investor full risk to the index - both upside and downside - plus dividends. In the example of a FTSE defensive autocall, you replace this risk profile with a defined return - 7% a year, say - for a defined risk.
Investors who currently have an allocation to the FTSE 100, which has generated more than 140% total return over the past 10 years, may decide that a high probability of 7% a year is a more appealing prospect at this stage of the cycle and use it within a diversified portfolio of equities.
The final quarter of 2018 was a volatile time for equity markets globally and very few asset classes aside from cash ended the year in positive territory. Autocalls, however, generated an attractive return. Research from FVC Structured Edge, an independent research service for advisers that covers the whole of the UK structured product market, shows an average return of 7.45% a year across all capital-at-risk structured products for the three-year period to the end of 2018.
We can, however, go back further to the start of the blue-chip UK index and show over that 34-year period, a FTSE 100 defensive autocall with a 35% downside protection buffer would never have been breached and lost an investor's capital and would have always paid the defined return.
The notable exception to all this would have been if the issuer was Lehman Brothers: while a small issuer of retail structured product market in the UK prior to its demise, Lehman Brothers did default in 2008 and structured product holders would have experienced losses.
While credit risk is currently low among global diversified banks, it is important to note that an investor holds debt issued by the financial institution over a medium to long-term horizon and the investor needs to be comfortable with that risk.
It is wrong to think of structured products as an asset class in their own right as they are simply investments that offer access to actual asset classes such as equities and, in the case of auto-calls, offer a high probability of achieving the defined return.
Nick Johal is a director at Dura Capital
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