Friday HighlightApr 17 2020

The value of structured products in uncertain times

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The value of structured products in uncertain times

Uncertain times amid an unprecedented global pandemic has left investors shaken.

The unknown tenure and severity of the current situation, combined with debate over the effectiveness of government policy and health of the nation over the long-term, may well define a generation for years to come.

While parallels can be drawn between now and the great financial crisis of 2007-2008, there are some important differences.

Banks are well capitalised with access to funding and liquidity which is currently the target of the new generation of ‘alphabet soup’ of monetary policies being enacted in global co-ordination.

These exceptional policies were new a decade ago, but are now tried and tested to ensure the financial system operates effectively. 

In addition, the long-discussed fiscal stimulus which is necessary as we reach the lower bound of interest-rates is becoming a reality, up to and including helicopter money.

Seeking income

In these exceptional times, amid heightened volatility and lower entry levels, investors are seeking alternative sources of return.

Structured products are investments linked to an underlying asset class, such as equities, and generate a defined return for a defined risk. 

In the UK, the most popular structured products of recent years are Autocalls linked to an Equity Index such as the FTSE 100, and these investments simply access an equity return in a different way. 

The FCA voiced concerns about all investments which can be allocated incorrectly, mis-understood or have returns over-stated and structured products have been no exception. 

We believe that Autocalls offer the highest probability of generating a return after fees of 5 per cent+ pa. 

With a very strong track record and high forward-looking probabilities of achieving their positive return, there is a strong argument for using Autocalls within a diversified portfolio.

Autocalls or Kick-out Plans, as they are often known, deliver a defined equity-like return through capping your exposure to the equity index and building a buffer of protection against the downside, thereby increasing the probability of said defined return. 

Yields available would normally range from c.6-11 per cent pa depending on the risk the investor is willing to take. However, due to the spike in volatility over the last few weeks, there are some even higher returns available. 

Most structured investments have credit risk to a financial issuer of the securities, usually a global bank. 

Over the last few weeks credit spreads on most major global banks have doubled, but from a very low base, which is testament to how well capitalised the banking industry is at the moment, and shows that the banking sector is a far cry from the great financial crisis.

Since then, banks have changed considerably by raising capital, lowering reliance on short-term wholesale funding and focusing on asset quality, giving more robust balance sheets and higher levels of equity. 

This is important as the returns are a contract between the investor and issuer who, subject to their solvency, must deliver the returns if pre-defined conditions are met. 

Those pre-defined conditions, in the example of a FTSE 100 Autocall, like the one described above, are transparent and determined from the outset - the only decision for investors is whether they are happy with the risk and return profile.

Risk

Regulatory risk is something that needs to be taken into consideration as well. 

The FCA voiced concerns about all investments which can be allocated incorrectly, mis-understood or have returns over-stated and structured products have been no exception. 

This has fed through to higher PI premiums if you advise clients on structured products. However, the FCA thematic review in 2015 addressed many legacy issues and set robust guidelines for manufacturers and distributors in areas such as;

  • Identifying a clear target market and using this information to inform the product development and distribution strategies
  • Ensuring structured products have a reasonable prospect of delivering economic value to customers within the target market
  • Strong monitoring of products and applying effective product governance ensuring customers are treated fairly

The FCA Thematic Review of structured products was arguably ahead of its time, with recent regulatory initiatives such as Mifid II and Priips catching the rest of the investment universe up. 

Arguably, all individuals now have the potential to be their own mini-pension fund manager.

Advisers who demonstrate a robust governance and investment process advising on structured products have successfully reduced their PI premiums and have truly demonstrated their independence by including these products.

Pension Freedom changes in April 2015 still represent one of the biggest opportunities for the structured product universe as it gives greater freedom in how you can access your pensions. 

While many of the popular strategies such as absolute return, low volatility and multi-asset funds have their pros and cons, an often overlooked part of the market is structured investments.

The defined return and defined risk profile of many of these investments lend themselves well to clients that are looking for market-linked returns, income or a combination of both.

Diversification

Pension freedoms have also placed a responsibility on investors and their advisers to manage sequencing risk and pound-cost ravaging in the short-term and inflation risk in the long-term to ensure they are able to maintain a standard of living in retirement. 

Arguably, all individuals now have the potential to be their own mini-pension fund manager having to deal with meeting their future liabilities with a given set of assets and managing longevity risks, among others.

With 10 year gilt yields just under 0.6 per cent pa at the time of writing, the favoured investment for traditional pension fund managers to match their liabilities with, i.e. gilts or other Fixed Income securities are severely curtailed.

With rates across the globe cut in emergency meetings a popular 1980s saying applies here... TINA (there is no alternative) to equities. 

However, equities are a risk asset class and, with higher volatility, have the potential to generate plus (or as we have seen over the last couple of weeks, minus) 30 per cent returns in any given year. 

While the +30 per cent would be a boon to retirement portfolios, it isn't required and the -30 per cent return has serious consequences. 

After all, just under 7 per cent pa compounded over 10 years will double a portfolio's value.

As we have witnessed over the last few weeks, there have been some of the most aggressive falls in the FTSE 100 and indeed all global indices in our lifetime. 

Many investors are worried and are suffering some heavy losses in their portfolios. 

However, if used as part of a diversified portfolio, structured products can take advantage of these volatile periods and indeed can benefit from them, as shown in the improved pricing and lower index entry levels. 

Nick Johal is a director at Dura Capital