If you’re still sceptical about an equity market recovery without an economic one, it’s easy to see the appeal of structural products. In a nutshell, you get exposure to the upside, but with a capital guarantee of some form in case markets fall out of bed.
Both the size of the market and the range of products on offer have expanded dramatically over the past couple of years. The UK market for structured investments in 2009 pipped £13.6bn – up 50 per cent on 2008 sales. Yet paradoxically, that growth has taken place against a backdrop of increased wariness on the part of investors.
Never had it so bad?
Some investment managers take rather downbeat view of the industry. In their opinion sentiment towards structured products is worse than before. Some advisers and investors are realising that they never really understood the risks of these products in the first place. Despite the alleged rise in sales, some selling got far fewer, mainly because there are fewer that can be recommended with full confidence, particularly in regard to financial strength and pricing.
The bottom line remains the fear of default on the part of the bank backing the product. After all, Lehman Brothers, which had underwritten a number of structured products in the UK market, collapsed in 2008, as did structured investment provider Keydata last summer.
However, most would argue that the likelihood of, say, Barclays or HSBC hitting the skids and being allowed to collapse without government intervention is pretty low compared to the risk of a nasty market correction. In such an environment, to investors for whom memories of global markets in freefall remain fresh and scary, structured investments offering full or partial capital protection may seem attractive, despite the counterparty risks lurking in the background.
Have your cake and eat it
Some supporters of structured products in this polarised arena claim that they have also been some of the best performing holdings for clients. They assert that they use such kind of products extensively, in conjunction with portfolio of other funds, and they have been fundamental contributors to their strong investment performance over the years. The example for the statement is the following: at the moment, the experts can get an Investec product with no protection on the downside, but paying 200 per cent of any rise in the FTSE. They have to take into account the credit risk of Investec, of course, but for investors prepared to accept that risk they still view it as an attractive proposition in comparison with any conventional FTSE tracker. Moreover, in supporters’ words, combining different maturity dates can help with tax planning; and the issue of managers’ performance fees does not raise its ugly head because costs are built in to the pre-defined benefits from the start.
So which structured products are proving most popular in these post credit-crunch days? According to Barclays Wealth – one of the main players in the arena – the poor rates available through bank deposit accounts have pushed many investors towards products structured to provide an income stream.
They come in two basic forms. “Reverse convertibles” pay a fixed rate of interest, monthly or annually, through the term of the product; but your capital is at risk if the market falls below 50 per cent of its starting point and fails to recover by maturity. Fixed Income bonds work on a similar principle, but with no risk to your capital; in return, they pay a lower rate of interest.
However, some independent financial advisers warn that many income-producing structured investments are paying pretty unattractive rates now. In some cases the income on a five-year ‘capital at risk’ product is close to or even lower than the highest five-year fixed rate savings account; that they consider not good value for money.
Some experts also picks out ‘kick out’ plans as another type of product that has tapped into the past year’s combination of a rising market and lingering investor wariness. These run for a set five or six-year term, but if the market has not fallen after the first year, investors receive a pre-defined annual return and exit the plan with their capital returned. If it has fallen, the plan continues to run, but with continuing annual break points at which, if the market has risen, investors will be ‘kicked out’ with a proportionate return on their investment. Clearly, such a product underperforms an ordinary tracker in a strong market, but it provides an element of certainty, plus early release for those who want to switch to something racier.
In fact, although many advisers intone the mantra of simplicity, Barclays reports that it’s the traditional guaranteed equity bonds, offering a percentage of exposure to a stock market index plus downside protection, that have slipped down the popularity tables. It can be explained by the fact that investors are increasingly expecting structured products to be reshaping the index, not simply tracking it.
In this context, a number of growth-oriented types of structured product are pulling the punters. Defined Returns plans, commonly known as ‘digital’ products in the market, protect your capital (unless the market falls more than 50 per cent over the term) and provide a defined return at the end of the term, provided the underlying index has not actually fallen by that time.
Experts state these are very popular in the UK, as investors like the combination of repayment of capital at maturity, plus a return that is not dependent on equity growth. For instance, L&G runs a plan that pays 57.5 per cent over the five-and-a-half year term, even if the market rises by only 5 per cent. Again, it’s not brilliant if the FTSE has doubled – but for cautious investors it’s a fair and relatively worry-free compromise.
Geared structured products or ‘supertrackers’ are useful for investors looking for relatively rapid growth and a controlled downside, perhaps because their retirement investments were hit hard during the credit crunch. For example: Morgan Stanley FTSE Tracker Plus plan, which pays 120 per cent of the index growth, uncapped, and protects 80 per cent of your capital against negative performance (so you would lose only 20 per cent, even if the FTSE fell to rock bottom). Experts like its “clean, straightforward structure”, and the fact that the level of capital protection is spelt out from the outset, thereby “helping to reduce a portfolio’s overall volatility.”
Some providers are also trying to sidestep the fixed terms inherent in most structured products; for instance, the Barclays Growthbuilders plans lock in a set annual gain each year, provided the index is up on the annual review date. And although the FTSE 100 is usually the defining index, it’s also possible to find interesting structured products tracking other indices. One such is Barclays’ Emerging Market Optimiser, which tracks an emerging market ETF but has a built-in risk adjustment process to mitigate the relatively high volatility of the sector and therefore make emerging markets a less risky proposition.
Some remain implacably against the use of structured products, arguing that their inflexibility, counterparty risk and complexity outweigh any advantages.
Structured products could work well within your portfolio, but it is vital that you and your adviser understand fully just what they set out to do, how much you stand to gain if things go well, and, crucially, how vulnerable your capital is. It’s also important to ensure the product is underwritten by high-quality counterparties, because if they do go to the wall you could face the total loss of your capital.