In today’s uncertain climate, financial advisers have to consider risk very carefully. How much risk is appropriate for different clients, and how it is managed are critical questions when putting together investment plans.
This is particularly important when looking offshore. With interest rates in developed markets being so low, any substantial losses will be hard to recover.
For selected investors, structured products offer a potential solution. These make use of derivative structures and bonds to create pre-determined pay-off profiles that are guaranteed at the end of a set term – usually three-and-a-half to five years.
The most appealing products provide exposure to equity markets through referencing specific indices, but also give full capital protection if markets fall. Essentially, investors receive exposure to equities, but at a substantially reduced risk.
“If you looked at a long term hierarchy of asset classes, from a return perspective we know that the best is listed equity and the worst is cash,” says Japie Lubbe of Investec Structured Products. “From a risk perspective it is usually the inverse, with cash being the least risky and equities the most. What structured products do, is to give you the risk of cash, but the reward of equity.”
What is important for any adviser, is to understand how this is achieved. This is critical not only because you must be able to explain the structure to your clients, but also so that you can satisfy yourself that it is, in fact, appropriate.
In the past, structured products were often opaque and difficult to unravel, and there are still some of these on the market. They should however be avoided, not least of all because they also tend to come with inappropriately high fee structures.
There is however a growing range of products that are essentially very simple. The capital guarantee is established through buying a bond that will usually mature at the end of the term at 100% of the initial investment, while the potential upside is created through taking one or more call options on a market index or indices.
If the index goes down, the investor therefore suffers no losses, because the bond provides full capital protection. If it goes up, the call options will realise gains which are often geared to more than 100%. This upside will however usually be capped.
Apart from the capital guarantee, there are three other significant benefits to structured products.
- Investors know from the outset what to expect. They are given a set of parameters and can be certain that their returns will coincide with those.
- Structured products always run over a set term. The best of them will offer daily liquidity if an investor really wants to sell, but it is easier to convince clients to stay invested if they were prepared to do so from the start.
- Structured products effectively re-set at the end of each term. This means that gains are locked in at that point and that compounding then happens off that new base.
Advisers do however also need to be aware of three potential issues:
- Investors will be exposed to the credit risk of the issuer. Effectively they are replacing market risk with counter-party risk, and this needs to be considered and managed within a portfolio.
- Investors will be giving up liquidity. They will only realise the full benefits if they stay invested for the whole term.
- Structured products do not pay any dividends. There is some compensation for this in the gearing offered, but there is no yield.
Ultimately, advisers that understand these products and are able to explain them clearly to their clients, will have another tool to add into a balanced portfolio. And in the current environment, alternative sources of risk and return can be very handy to have.
Under RDR, accountability for correct advice will be more evenly born by advisers and product providers. Experience has taught us that the wise financial adviser will make sure that he understands 100% what he advises on, and advises his clients accordingly.