Investing in Siructnred Products

Investing in shares on the stock market has always carried an element of risk, and some smaller punters — and even a scattering of megawealthy investors — get as much of a kick out of "playing" the market as dedicated race-course betters do from seeing an outsider they have picked romp home at odds of 60 to one. For on the markets, as at Epsom or Aintree, there are no absolute certainties. Even Britain's blue chip companies — the top 100 which make up the Footsie Index — are not immune to sudden and unexpected failure.

Of course there are completely safe invest ments — such as fixed deposits in commercial banks (though even these have been known to fail) — in the current climate of historically low interest rates, returns on these rarely keep pace with the declining real value of an investor's cash. What many wantis safety — or at least a semblance of safety! linked to realistic capital gains or income.

edge in the area of structured products, Gardner claims.

The appeal to indi vidual investors prob ably lies in the fact that each product is tailored to a sp>ecific scenario or to his or her needs, and that it is set in such a way as to mitigate risks from changes in foreign exchange rates or fluc tuations in the cost of borrowing. While pro viding for diversifica tion and the efficient use of an investor's capital, moststructured products also offer the ability to take a "com plex" view through a single investment.

The SG

Though they are rela tively new investment vehicles, "structured products" both meet this need and are also being demanded increasingly by high net worth indi viduals — a demand which banks are gearing themselves to meet and a ground-breaking area across which SG Hambros is cutting a suc cessful trail.

SG Hambros currently puts to gether as many as four or five struc tured products a month, Peter Gardner, head of the bank's prod uct development team,told a bank ing seminar in London recently. In the past year there had been a dou bling in the assets under manage ment of structured products, he added.

All very well, but what exactly is a "structured product"? Although no single definition has been estab lished, they can be summarised as financial products which have been created by "combining two or more financial instruments — one of premises which is generally a derivative to create a single product," Bruce Duckworth ofSG Hambros(Gibral tar) explains. They are also linked to one or more underlying prices, indices or rates...and paymentis set at "one or more future dates."

Generally their capital is pro tected and returns are contingent on the performance of the under lying investment; or they offer guaranteed or contingent returns— with redemption of capital contin gent on the performance of the un derlying investment.

Because Its parent Societe Generale is"a powerhouse in de rivatives" this "helps enormously with the construction of the prod uct" and has given SG Hambros an

Inevitably there are also potential draw backs. As Gardner points out capital pro tection applies only if the instru ments are hold to final maturity;in the case of many equity-linked products there can be loss of divi dend income;and there is potential volatility in "mark-to-market valuations" as a result of fluctua tions in interest rates or the value of embedded options."

The bank is also increasingly of fering its clients Constant Propor tion Portfolio insurance (CPPI) structuring techniques — a more sophisticated vehicle that enables active management of the struc tured product, Gardner told the seminar.

"This enables assets to be bought and sold throughout the life of the structure to ensure the optimum level of both risk and investment exposure are maintained," he ex plains.

In a low interest rate environ ment such as we have experienced for almost the past decade or so, CPIMs arc particularly attractive, the bank argues."ACPPI structure borrows money to invest in the risky assets — obviously the ex pected return needs to beat the cost of borrc>wing,'Gardner says."If the interest rate rises and becomes higher than the expected return on the risky assets, the manager will stop the leverage — though not the investment,

"One of the problems associated with CPPI is that while the struc ture allows for the active manage ment of the underlying invest ments, it does not allow for active management of the leverage," Gardner admits.

However, second generation CPPIs arc more sophisticated and increasingly allow banks to limit volatility while more actively man aging the multiplier part of the structured product. New tech niques allow for the active manage ment of the CPPI parameters in cluding leverage,as well as the un derlying investment.

These second generation CPPIs have three levels of management, according to SG Hambros:

• The alpha of the underlying in vestment managers — the asset allocation based on market ex pectations;

• The mathematical rebalancing of the CPPI — rebalancing between the underlying investments and the non-risky assets based on market trends; and

• The alpha of the product man ager — the active adjustment of the leverage factor and other CPPI factors, depending on the product manager's expectations of the markets' movements."

"Structured products are an in vestment area that still has signifi cant room to expand and is con stantly changing, benefiting from developments in financial engi neering and derivatives trading," a local SG Hambros spokesperson adds.