Structured products have been successfully used for many years by wealthy individuals and investment institutions, allowing positive returns to be generated even when mainstream investment markets have been in negative territory. At the same time they have been marketed under various guises over the years and have sometimes been sold inappropriately by unscrupulous or poorly informed “advisers” and investment companies, often to investors who were unaware of what they were really investing in. There have also been some notable horror stories, from “precipice bonds” to the collapse of Lehman Brothers, who provided the “guarantee” for a number of structured products. They are often described by investment professionals as the “marmite” of investment products; you either love them or hate them. However, there is now a proliferation of these products available through high street banks, private banks and other investment institutions and it is arguable that they have now come of age and could be considered as a tool to be used in some investment portfolios. That said, we are concerned by the number of people we speak to who are either tempted to invest in these products in the wrong way or for the wrong reasons Conversely, there are people who are missing out on the benefits they might provide, if used in the right way, because of a lack of understanding. They could be compared to a medicinal drug – used correctly they can prevent or minimise pain or suffering and encourage a healthy outcome, but misuse them at your peril! Structured products can be a useful tool but they should only be used as part of a wider strategy and then only if the investor is fully aware of the pros and cons; and most importantly they should only be used after seeking professional, impartial advice from a qualified and well informed adviser. So, the purpose of this note is to dispense with some of the myths and lay out some of the facts.
SO WHAT IS A STRUCTURED PRODUCT?
Simply put, a structured product is any investment in any asset where the holder does not directly hold the underlying asset, but whose return is linked to the asset in some way (usually, but not always, pre-determined at outset). The scope of possible structured products is endless but the following is a sample of some of the main features which can be included: • Most of them have a fixed term of investment typically anything from 2-6 years, although some are shorter or longer term. Some pay out early if certain conditions are met, for example if the level of the FTSE 100 index is at or higher on an anniversary than it was at the issue date. • A large proportion of the structured products available to the general high street market in the UK are linked to the performance of the FTSE 100 index. However, they can be linked to any asset which has an easily measured price, such as a commodity like gold, oil, grain or soya beans. They are sometimes linked to a “basket” of assets or indices so that the risk or potential for return is spread. • Other examples are products linked to currencies, weather patterns or property values. • The return to the investor can be based on the value of the asset increasing or decreasing. • Many of them have a built-in underlying capital protection so that the attraction to the investor is that they can benefit from some or all of the increase (or decrease) in the value of the asset but have a reduced exposure to the loss of their capital if the movement of the asset price goes against them. It would probably be helpful to describe briefly a couple of examples of products available at time of writing: Please note that this is not a full description of either product or their risk factors and should not be construed as a recommendation or endorsement of either product. Example 1 Product with a fixed return on half of the capital after 1 year and on the remaining half of the capital a return linked to a commodities index after 5 years. 5% gross interest on half of the original capital after the first year, plus 50% of any rise in the RBS Risk Stabilised Commodity Strategy Index on the remaining half of the original capital after 5 years. This five-year product aims to return half of the original capital investment after one year, plus a 5% gross interest payment on that portion of capital, which will be returned on the first anniversary. The remaining 50% matures at the end of the term and will be uplifted by 50% of any rise in the RBS Risk Stabilised Commodity Strategy Index, subject to averaging over the final year of the investment term. If the Final Index Level is below the starting Index level, no additional growth will be achieved; however the balance of the investment should still be returned on the final maturity date. The RBS Risk Stabilised Commodity Strategy Index aims to take advantage of the potential international growth in commodity prices from exposure to the RICI Enhanced Excess Return Index. This investment is capital protected (subject to counterparty risk) so the investor should receive their capital back in full even if the underlying index is down at maturity. Example 2 Product linked to FTSE 100 index. As long as the index does not fall by more than 40% during the term, the investor receives their initial capital back plus a return of 1% for every 1% rise or fall in the FTSE 100 index at the maturity date. If the index falls by more than 40% at any time in the 3 years, the capital protection disappears and the investment tracks the index up or down on a 1 for 1 basis. So if the index is up at maturity the investor receives their capital plus 1% for every 1% rise. If the index is down they receive their capital minus 1% for every 1% reduction in the index. This only applies if the index breaches the 40% fall condition during the 3 years.
WHAT’S “UNDER THE BONNET” – WHAT MAKES THEM WORK?
There are a lot of different ways of creating structured products, as you would imagine. However, most comprise two parts. In simple terms the first part provides the return of the capital invested (or some of it), and the second part provides the upside return linked to an asset price or index. Generally speaking there are two main types of structured product:
This is the simplest type. Here the larger part of the investment is placed in some kind of deposit, often specifically created for that product. An example would be a certificate of deposit issued by a bank with a fixed term and fixed payout at maturity. This provides the full or partial return of the initial capital at maturity. The remainder of the investment is then used to buy a derivative such as an option or warrant linked to the price of the underlying asset or index. This part provides the return and is a bit like a bet on a horse where you either lose your initial stake or win a multiple of it if the bet goes in your favour. The clever thing is that using such derivatives can allow you to win if the asset goes down or up. To revert back to the horse-racing analogy it is like betting on a horse winning and/or the same or another horse losing or, in other words, “hedging your bets”. Example 1 above falls into the category of structured deposits. Structured Capital at Risk Products (“SCARP”) For tax reasons the majority of structured products used in the UK at the present time fall into the SCARP category. This is partly due to low interest rates making the structured deposit type less attractive. But the main reason is tax based as a structured deposit is subject to income tax (up to 50%). On the other hand, the SCARP type can be structured to be subject to capital gains tax (maximum 18%). This type of structured product uses two or more derivatives instead of a deposit, so, typically, one derivative provides the full or partial return of initial capital and the other the upside return if the “bet” works out. To go into too much detail here is outside the scope of this note and requires a more in-depth understanding of derivatives such as options and warrants. However, and this is probably the most important point of all, these derivatives are generally quite straightforward once they are understood and they do what they say as long as the issuer of the derivative is there to meet its promise at maturity (more on “counterparty risk” later). This is why it is so important to get advice from an adviser who understands how these components work and can assess the risks. Example 2 above falls into this category.
WHO ISSUES STRUCTURED PRODUCTS?
Although they are often marketed and distributed by institutions such as high street banks, private banks, building societies, insurance companies or one of the companies which specialises in packaging structured products, the underlying product is usually issued by an investment bank, which provides the various components of the product. The investment bank will usually (but not always) issue both or all parts of the product. Although the product may appear to be provided by the well known institution, it is important to know who the ultimate issuing investment bank (“the counterparty”) is, as the failure of the investment bank could mean a complete collapse of the structured product and total loss of the capital invested. This is what happened to structured products where Lehman Brothers was the counterparty, although investors in products issued by Lehman Brothers are still battling to get some compensation. Effectively they have joined the queue of creditors of the failed company.
WHAT WERE “PRECIPICE BONDS”?
These were investments which offered a very high rate of “income” during the term and a return of the initial capital (sometimes after deducting the income already paid) if the index to which they were linked did not fall by more than a certain level (typically 20-30%) during the term. If this protection level in the index was breached then the investor’s capital would be reduced by typically 1- 3% for every 1% fall in the index at maturity. In the worst examples, if the index level was breached at any time during the term, even if it subsequently recovered, the investor lost 3% for every 1% fall in the index, AFTER suffering a reduction for the “income” already received. Clearly, the risks associated with these products were significant and many were sold “off the page” to unwitting investors. They have been the subject of large scale compensation pay-outs by the companies which created or distributed them, based on lack of transparency in the way they were explained and marketed.
ADDRESSING SOME OF THE CONCERNS
“Counterparty risk is a major concern”
Following the banking crisis we have recently experienced, the comments that we still see in the marketing literature of some advisers that “if XYZ bank fails we will have more to worry about than our investments” seem extremely glib. Very few investment professionals previously questioned the findings of the rating agencies that gave banks their highly rated status only to watch those same banks fail or become the subject of government bail-outs. However, the effect has been that the strength of banks’ balance sheets has been pushed to the forefront in the decision making process even when making straightforward deposits. The same is true of the counterparties to structured products. Whereas, in the past hardly any attention was given to the counterparty, it has now become the most important factor in deciding whether a structured product is appropriate. In fact the FSA now places a requirement on regulated firms to carry out greater due diligence on the structured products they recommend than simply looking at the published credit-rating. So, because of the banking crisis and the failure of Lehman Brothers, counterparty risk is now under the spotlight and informed decisions can be made when making investments which are backed by a bank. “They are not good value because they do not reflect the dividends which would be received if you invest directly in the index or the shares.” Firstly, it is true that the majority of structured products do not pay out the dividends or interest on the underlying asset. However, it is not fair to say that this means they do not offer good value. The decision to invest is usually based on a view on the potential increase or decrease in value of the underlying asset but with a need or desire to limit the risk of loss inherent in investing directly in that asset. Whilst it is important to take into account the potential return available, including dividends, by investing directly in the asset, it must be remembered that there is always a cost involved (rather like an insurance premium) for the provision of capital protection. The loss of the future flow of dividends is simply one of these costs. There are in fact a number of products becoming available which do include dividends in the overall return they aim to provide.
“They are illiquid and cannot be surrendered before maturity”
Most structured products are designed to provide a return on a fixed date in the future if certain investment conditions occur. On that basis they should not be entered into unless the intention is to remain invested for the duration of the term. However, in Europe and the U.S. there is an active secondary market in structured products, and increasingly the underlying warrants or options used in structured products on the UK market can be traded on an exchange and therefore sold reasonably easily. It is however true that there is no certainty as to the value which will be received if a structured product, or its constituent parts, is redeemed early so the above comment is partly true; usually at a lower level than the potential underlying value.
“They are too complicated and they are not transparent”
Once the constituent parts of a structured product are understood, including who the counterparty is and what the risks are, structured products can be considered to be more transparent than most other investments. Once any variables are understood and accepted, the performance of a product is pre-determined by the conditions set out in its terms. The important thing again is to fully understand at outset what could happen and what the risks are.
“They are expensive”
The costs of setting up a structured product are built into the initial pricing and can be up to 3% or 4% of the initial investment. This will normally include a commission payable to the adviser who recommends the product. If you use an adviser who does not work on a commission basis, this can be used to reduce the direct cost of the investment, although you are likely to have to pay the adviser a separate fee. The cost is a factor in determining the terms the product offers and, there are generally no further costs incurred. Because the cost is in the price, it affects whether the product is competitive or attractive and that decision is fairly straightforward for the investor and their adviser. It should however be borne in mind that the costs are priced in up front and are not recoverable if the investment is redeemed or sold early.
THE BENEFITS IN SUMMARY:
Structured products, when used correctly can: • Make positive returns in falling markets • Provide exposure to risky or volatile asset classes whilst limiting the investor’s downside risk • Allow an investor to diversify their portfolio by providing exposure to assets which are difficult to hold directly (such as individual commodities) • Can increase exposure to an asset’s potential upside • Provide a predictable return if an expected set of circumstances occurs • Provide a structured “trade-off” of risk for potential reward
THE RISKS IN SUMMARY
The main risks involved in structured products are: • Counterparty risk – the risk that the provider of the product fails • Lack of liquidity – it may not be easy or possible to liquidate the investment before maturity • Opportunity risk – the risk that being tied in to the investment might cause a missed opportunity to benefit from direct investment or timing decisions • Getting the “bet” wrong – simply put, placing a reliance on an expected set of circumstances which doesn’t happen and then being tied into that decision until maturity • Investor Compensation – If the product is protected under the FSA’s Investors Compensation Scheme it is likely that this will only protect the first £50,000 of the investment in the event of fraud or negligence. In the event of the collapse of the counterparty, it is likely that the Investors Compensation Scheme will not apply. If the investment is held via a third party “wrapper” such as an offshore insurance bond, there is a likelihood that the Investors Compensation Scheme will not apply.
SO WHEN SHOULD THEY BE CONSIDERED?
In our view, structured products have a place if they are used as part of a diverse portfolio. They should not be used as a large part of a portfolio as this becomes a gamble rather than a strategic investment decision. However, they can allow an investment to be linked to an asset type which would otherwise be avoided, either because a negative view is held on that asset, or the asset is too volatile. Other uses might be where an asset has a reasonably predictable, but low, expected return or range of returns. In this case a structured product can be used to enhance the return on the asset by providing an increased return for every percentage change in the price of the asset. If a known capital expenditure is to be incurred at a point in the future, a structured product can be used to potentially provide a better return than cash on the capital set aside to meet the expenditure. This might mean foregoing interest on the cash for a potentially higher return if the underlying asset performs as expected (but caution is required with regard to liquidity). They can provide a means of hedging currency exposure where there is a known requirement in another currency at a point in the future (e.g. purchase of foreign property).
At Fiducia we will use structured products as a part of a client’s portfolio where we feel it is appropriate, and only then if the client is completely informed and in agreement that the use of such products helps meet their investment requirements. In keeping with everything we do, we only invest in “best of breed” structured products having first carried out a full risk assessment. If you would like to discuss this subject further, please feel free to contact your normal Fiducia adviser.