Structured products have come a long way. From a specialised, exotic investment tool, they are now mainstream, and financial advisers are now more comfortable investing in them on behalf of clients.
As the acceptance of structured products has grown, so has the need to keep clients informed about their role in an investment portfolio and the specific types of products available.
So, what do advisers and their clients need to understand before proceeding with an investment? Let’s look at some of the key issues.
Investment strategy: As an adviser, you’ll have a detailed investment strategy in place for your client that takes numerous factors into consideration, such as life stage, income requirements and risk tolerance. A structured product needs to fit into this broader strategy.
While each investor’s investment plan will differ, broadly speaking a structured product will be included in a portfolio as they are an ideal alternative that can be used for several reasons:
1) to build up an exposure in a particular asset class, e.g. offshore country exposure (such as the US or UK) or sector-specific exposure, such as tech – or finance-specific indices
2) to gain capital protection in a specific market or index where the returns might be volatile
3) as a useful strategy to diversify currency exposure across your investments
4) to take advantage of short or medium-term market conditions where the use of gearing can amplify returns while protecting the downside.
While each structured product is different, most share the following features, which could influence the decision around which structured product to invest in….
Capital protection: Probably the best-known feature of structured products. A typical structured product – usually with a maturity of between three and five years – will have 100% capital protection, or with protection of losses up to a certain percentage (say 20% or 30%). This feature is attractive for investors concerned about stock market volatility over the medium term.
Geared returns: This simply means that investors earn a multiple of the return of the underlying index or group of indices. Returns are often capped at a certain level, but investors will still earn the multiple up to that level, at which point the investment return is capped. For example, the structure may give the investor two times the return of the underlying index, capped at 60%. So, if the index grows by 50% over five years, the investor will earn a 100% return. If the index grows by more than the 60% cap, the investor will earn 120% (the 60% times two). Only if the index returns more than 120% will the investor lose out on the upside beyond that level. These payoffs are therefore very useful for investors only mildly bullish about the underlying market.
Returns can be in rands or foreign currency: It’s important to look at the currency to which the product is linked. Structured products will often link returns to a well-known stock market index, such as the MSCI World, S&P 500, or FTSE 100. Others will be linked to a portfolio of various indices. Some may offer the return in US dollars, euros, or sterling, while for others, the returns will be in rands. Investors will choose the investment product depending on which currency exposure they are looking for.
What are the liquidity requirements of the investor? Structured products come with a defined term – three or five years are the most common investment periods. While most issuers will provide some sort of commitment to pay out, should the investor need to access funds before the product matures, this can result in the investor not realising the full potential of the investment. On this score, investors in structured products should only invest with cash that they can tie up for the duration of the investment period.
What are the risks? Structured products are generally low-risk investments but are not risk free. Investors should, for example, be cognisant of credit risk. A structured product is essentially a contract between the investor and issuer, with the latter promising to deliver the returns described in the contract. Most structures will be issued by well-known, highly rated banks, so the risk is generally low, but not zero. On this score, it should be noted that the recent high-profile takeover of Credit Suisse by UBS would not have a negative effect on the underlying credit of structured products that were linked to the senior debt of Credit Suisse.
Finally, each structured product will have its own combination of features, but if the adviser and client are prepared to talk through their role in a holistic way and to also go through the features and scenarios for each product, they can be a true enhancement to an investment strategy.