Structured products in an unpredictable world

BRIAN MCMILLAN Investec Structured Products

Structured products have come a long way in recent years. From a specialised, exotic investment tool, they have become mainstream and financial advisers are now more comfortable to invest in them on behalf of clients.

However, even as they grow in popularity, there’s a responsibility on issuers and advisers alike to keep clients informed about structured products, their role in an investment portfolio and the specific types of structured product and their features.

In this article, we go through some of the key investment issues advisers and their clients need to understand before proceeding with an investment.

What is the client’s broad investment strategy?

As an adviser, you’ll have a detailed investment strategy in place for your client, taking into account life stage, income requirements, risk tolerance and so on. A structured product needs to fit into this broad strategy.

While each investor’s investment plan will differ, broadly speaking a structured product will be included in a portfolio for two reasons: to build up an exposure in a particular asset class or to hedge an existing strategic investment decision.

This is useful for investors with a long-term holding but who wish, at certain points in the market, to either hedge their exposure in the short or medium term, or to take advantage of short- or mediumterm market conditions. There are many structured products that provide exposure (often geared) to a particular global index in a foreign currency that the investor may feel he or she doesn’t get from a typical balanced portfolio. The advantage of using a structured product in this way is that it doesn’t require accessing an investor’s offshore allowance to do so or to breach the prudent investment guidelines that govern retirement investments.

Moreover, structured products usually come with capital protection, whereby some or all of the potential downside in the underlying market is limited. Thus the investor enjoys protection and participation in the upside – as noted above, often geared.

STRUCTURED PRODUCTS COME WITH A TERM INVOLVED

What are the liquidity requirements of the investor?

Structured products come with a term involved (three or five years are the most common investment periods). While most issuers will provide some sort ofcommitment 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 – bear in mind that most structured products are designed to be held to maturity.

Typically, we would advise investors in structured products to only invest with cash that they can tie up for the duration of the investment period.

Does the investor understand the specific features?

We spoke above about gearing and capital protection. Gearing simply means the investor gets a multiple of the upside returns of the underlying index (say two or three times). While this is an excellent feature for most investors, it’s important to note that this is usually capped at a certain level. So if the underlying index advances beyond a certain level, the investor may not enjoy that full upside.

Similarly, capital protection may be limited to, say, the first 30% of the downside of the underlying index. Depending on the structure, the investor may be exposed to the full extent of the loss beyond that. Falls of this degree are very rare over five years, but it’s still important that the investor understands the downside potential.

Investors should understand also that they are foregoing the dividend portion of the return on the underlying index. This is because, when the issuer puts together the structured product, the prospective dividend income is generally deployed to provide the capital protection.

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 in an investment strategy.