Friday Highlight  

Structured products can help in uncertain times

Structured products can help in uncertain times

In September 2008, the collapse of Lehman Brothers marked the start of the global financial crisis, the worst economic event since the stock market crash of 1929.

Over a decade on, we can look at the causes of the crisis and the lessons learned, but most importantly, we can see how the crisis sparked a complete transformation of financial markets.

One type of investment that has undergone significant change in particular over the past decade is structured products.

Here, we take a closer look at how events in 2008 have shaped the structured products industry in the UK, and what this means for investors today.

A regulatory revolution

One of the positive legacies of the financial crisis is a tighter regulatory environment.

Regulations have increased significantly, with the aim of creating a safer, more resilient banking system (for example, the Dodd-Frank Act in the US and Basel III in Europe).

Measures include requiring banks to hold more and better-quality capital, heightened supervision from regulators and better monitoring from within banks themselves to test their ability to cope with market stress.

All measures that are very important and help us all sleep better at night.

They are particularly relevant for structured products, where investors rely on the ‘counterparty’ they invest with to remain solvent.

However, we should not lose sight of the fact that while regulation looks to make industry-level improvements, ultimately it was individuals who were affected most by the crisis.

With livelihoods destroyed and portfolios decimated, it was arguably the man on the street that paid the highest price.

Regaining the trust and confidence of investors has been a long journey and something that has gone beyond a new set of regulations.

Why should investors consider structured products in a post-crisis environment?

The financial crisis has changed the way that investors behave.

People are more acutely aware of the risks of investing than ever before, and accept that no financial institution is ‘too big to fail’.

But, this does not mean that investing is entirely off the table – more that a different approach is required with a greater emphasis on understanding the risks of markets and the investment products  linked with them.

As the effects of the financial crisis have abated and regulations have tightened, investors are regaining confidence and beginning to look for new products that can help diversify their portfolios.

Here, we list the three important lessons that investors should have learned since the financial crisis and how structured products can play a role in investment portfolios today:

  1. Markets can fall as well as rise: Historically, it was easy to believe that investments always increased over the medium / long term. In fact, it was a similar expectation about housing prices in the US that was the catalyst for the entire financial crisis. However, poor performance from the absolute return sector or even well-regarded investment managers are a stark reminder that this is far from the case, and that investors should always prepare for the unknown. Unlike most traditional investments, structured products can be designed to provide a return even if markets do take a turn for the worse, and are therefore useful tools to add to a portfolio to help investors defend themselves against market falls as well as benefit from the rises we hope and expect.
  2. Understand what you buy, in particular the risks: Pre-financial crisis, it was easy to get caught up in the hype of a ‘great’ investment, without actually understanding fully how it worked and how it generated returns. Margot Robbie’s monologue in the film ‘The Big Short’ illustrates perfectly how the widespread use of jargon prioritised ‘expertise’ over ‘understanding’. But times have changed considerably, and investment providers today are expected to be able to explain their products using simple, clear language, in a way that is easy for any investor to understand. The structured product industry has led the charge in this field. Firstly, providers design products with clearly defined outcomes (and risks) and secondly, significant resources have been applied across the industry to make sure product explanations are clear, fair and not misleading, helping investors understand what those defined outcomes could be.
  3. Not all investment products are suitable for everyone: The very idea that Lehman Brothers would collapse was unthinkable before 2008. And with such thinking and lack of understanding, came the risk that investors, who could ill afford to lose their money, held unsuitable products.The risk of holding (and advising on) inappropriate investments is arguably one of the fundamental risks of investment and one that has thankfully been significantly mitigated through changes in regulation. Structured product providers carry out significant research and clearly define a ‘target market’ for their products, identifying the type of retail investor that the product is designed for, and the investment needs that it has been designed to meet. The introduction of a risk score, via the Key Information Document, is also a useful tool for making sure that a product is a suitable match for an investor’s risk appetite.

Learning from past mistakes

A decade on, we have come out the other side of the financial crisis, but it has left a permanent impact on markets.

As uncertainty looms regarding Brexit, tensions escalate in the Middle East and global growth flatlines, it is more important than ever to look back and remember the important lessons that the financial crisis taught us, and invest in products that are right for us as an individual.