Over the past couple of years, the financial world has seen big swings as equity markets have responded to the changing economic environment.
Markets have oscillated from the steep losses seen in late 2008 to the recovery staged in 2009. The start of 2010 has seen a return of nervousness, with most major equity markets either flat or down in the first two months of the year. As this uncertainty remains, investors could be looking for ways to limit losses in their equity portfolios.
Of course, structured products that offer capital protection are one way to achieve this. They can be added to a broader equity portfolio to help limit downside exposure while still retaining the potential for some upside. But what different types of capital protection are available, and at what cost to the investor?
Most structured products work in a similar way: the provider uses the proceeds from subscriptions to do two things. First, they buy a derivative contract to give a growth or income return. Second, they buy assets to secure investors’ capital (provide the capital protection).
The higher the proportion of investment proceeds spent on the assets to secure investors’ capital, the less is available to spend on the derivative contract to generate the return. Experts know using higher credit-quality assets to provide capital protection is more expensive. As a result, the terms available on a lower counterparty risk product will be less attractive than terms on a structured product with more counterparty risk. But interest rates are also a key factor. With interest rates well below long-term averages, this means full capital protection is currently very expensive to provide. This gives product providers a dilemma: how to construct a structured product that offers a good balance of protection and performance potential?
One solution that has been very popular over the past two years is ‘soft’ or ‘contingent’ capital protection. This is where investors’ capital is protected in full, as long as the underlying asset does not fall below a pre-determined barrier, usually set at about 50% of the underlying level at the investment start date. This barrier can either be observed throughout the investment term, or at maturity only.
‘Soft’ protection is much cheaper than full capital protection, because investors are being asked to take on additional risk: they are being asked to take the view that the underlying asset will not fall by more than the pre-determined amount. This means products offering ‘soft’ protection will typically give greater potential for returns than those offering full protection.
For example, Morgan Stanley offers two products with the same payout, but one of which provides full capital protection (the FTSE Protected Growth Plan 33) and the other provides ‘soft’ capital protection (the FTSE Kick Out Growth Plan 3). Both plans offer the chance for early exit after three years as long as the FTSE has risen by 10% or more, otherwise investors receive a participation rate in any FTSE Index growth at the six-year maturity. By offering these two products side by side and seeing the difference in the returns available, specialists can see exactly how much more full capital protection costs the investor than soft capital protection: in this case it costs investors 30% on the early exit return and 10% participation at maturity.
Investors have to decide whether they are willing to take on the additional risk to achieve these greater potential returns.
The limited downside alternatives
But ‘soft’ capital protection is not suitable for all investors. It may be tricky to understand and some investors might not want to take a view on what level they expect the underlying asset to remain above. So what are the alternatives? Up until recently, there was little choice, apart from investing in fully capital protected products, but there is now a new breed of simple payouts hitting the market that could be a good solution for these investors: products where investors are exposed to the downside of an underlying risk, but only a fraction of it.
For example, investors in Morgan Stanley Tracker Plus Plan 2 will lose capital if the FTSE Index performance is negative over the six-year term. However, this will be limited to one-fifth of any negative index performance. The minimum capital repayment at maturity would be 80%, and this would only happen if the FTSE Index were to fall to zero. In return for accepting 20% of their capital at risk, investors can receive an uncapped, leveraged return if the index performance is positive.
This new ‘limited downside’ solution may appeal to investors who would typically look at tracker-type payouts such as ETFs. Of course, investors need to consider the risks associated with an investment, such as the counterparty risk of the issuer. As with any investment product, investors need to ask themselves whether they are comfortable with the credit quality of the institution providing the payout.
Regardless of what level of capital protection is on offer, this is worthless if the issuer were to default. Counterparty risk considerations should be part of the investors’ decision-making process. However, unlike an ETF, this new solution is designed to outperform the underlying asset on both the downside and upside. What’s more, the leverage on the upside could be enough to compensate investors for any foregone dividends (especially considering that dividend yields remain low).
One of the key benefits of using structured products in a portfolio is their flexibility in terms of payout. For years, experts have seen products offering different ways to gain upside exposure including fixed payouts, early exit features and varying degrees of participation in an underlying assets performance. They have also seen innovation relating to counterparty risk, with structured deposits and collateralised products proving popular with investors.
More recently, they have seen greater innovation in terms of downside exposure, driven by the high cost of full capital protection in the past couple of years. As well as fully capital protected products, investors now also have the choice between soft protection and ‘limited downside’ products. As market uncertainty remains, these different degrees of protection can be useful for investors looking to limit the risk of loss in their equity portfolios while still retaining some potential for returns, should markets be positive.