In the interests of transparency and balance, Nick Johal acknowledges some major risks associated with investing in structured products, which underline that these are not necessarily low-risk investments
So are structured products too good to be true? After all, the historical returns are compelling, with limited chance of capital loss and returns in the region of 6% to 8% a year for autocalls, while interest rates in the UK remain at, or close to, historical lows.
Some recent media attention has focused on the compelling risk-adjusted returns and benefits of adding structured products to a portfolio of investments. With low interest rates and after a 10-year equity bull market, these investments are able to deliver equity-like returns with a high probability of achieving them. The sector has done well to highlight how structured products offer an attractive defined return/defined risk proposition, benefitting those approaching drawdown or indeed in the decumulation stage.
This all sounds excellent - but my background is in fixed income, where the upside looks after itself. The downside is where risk resides and it is more difficult to assess as it is forward-looking. Therefore, in the interests of transparency and balance, it is important to acknowledge some major risks associated with investing in structured products, to show they are not necessarily low-risk investments.
This is inherent in most structured products as the underlying securities are issued by banks. Lehman Brothers was one casualty of the global financial crisis, defaulting on its liabilities in September 2008. Banks have changed considerably since then, however, including with regard to raising capital, lowering reliance on short-term wholesale funding and focusing on asset quality, giving more robust balance sheets and higher levels of equity and credit spreads while credit default swap levels have tightened considerably.
While counterparty risk is currently low, this may change over the investment term and is not a driver of returns in most structured investments. Diversifying issuers can mitigate some of this risk but, while bank credit spreads are tight and range-bound, it makes sense to invest in the highest-rated issuers.
Historical analysis on global developed market equity indices shows zero or extremely few periods of capital loss, except Japan in the 1990s, where the Nikkei 225 index is still 45% off the highs it reached in the late 1980s.
Investors are placing their capital at risk for a high probability of generating return - for example 7% a year - but, in the event of a secular bear market that does not recover, you would not receive this return and would lose capital on a one-for-one basis without dividends or interest over the period.
In this scenario, dividends would almost certainly be cut, as would interest rates - perhaps into negative territory so the opportunity cost is arguably lower. Investing in global diversified indices like the FTSE 100 helps manage this risk, however.
Plan manager risk
There have been examples historically where plan managers cease to exist and, while this has not impacted returns of the underlying security and plan outcomes, clients have been saddled with additional administrations costs and burdens. Due diligence on the plan manager and/or parent company should provide comfort to mitigate this risk.
The Financial Conduct Authority (FCA) voiced concerns about all investments that can be allocated incorrectly, misunderstood or have returns overstated. Structured products have been no exception and this has fed through to higher professional indemnity (PI) premiums if you advise clients on such products.
The FCA thematic review in 2015 addressed many legacy issues and set robust guidelines for manufacturers and distributors in areas such as:
- Identifying a clear target market and using this information to inform the product development and distribution strategies;
- Ensuring structured products have a reasonable prospect of delivering economic value to customers within the target market; and
- Strong monitoring of products and applying effective product governance ensuring customers are treated fairly.
The thematic review was arguably ahead of its time, with recent regulatory initiatives such as MIFID II and PRIIPS catching the rest of the investment universe up. Advisers who demonstrate a robust governance and investment process advising on structured products have successfully reduced their PI premiums as well as truly demonstrating their independence by including these products.
This might seem like a long list of risks but, compared with investing into a large global value stock - for example BP, which has market risk, interest rate risk, dividend risk, geopolitical risk and so forth - the list seems manageable.
So, yes, there are risks but they are defined. After all, a coupon of 7% a year far exceeds that of 10-year gilts, which yield less than 0.8% a year. We encourage advisers to understand these risks and decide if the risk/return profile fits an investors individual risk appetite and portfolio.
As part of a diversified portfolio, however, structured products such as autocalls have demonstrably improved investor outcomes by giving the highest probability of generating long-term growth. We would prefer investors to understand the investment risks and make an informed decision to invest rather than buy based on past performance or the perception that these are low-risk investments.
Nick Johal is a director of Dura Capital
A contract, not an asset class
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