Structured products suffer from some misconceptions that may lead to them being ignored by financial advisers and their clients. There are some key messages that the industry needs to get across, regardless of the specific product being promoted. These messages need to give advisers understanding and confidence so that structured products can form part of the portfolio planning process for all clients. Structured products are not the answer to everything. But they are an important option and should always be considered.
Sitting between cash holdings and equities, structured products are often seen as a way to create greater growth potential from money that would otherwise be sitting on deposit. While this is valid, it's only half the story. Structured products can also be used effectively as part of investment portfolio planning to cap or control equity investment risks.
By giving up some of the equity return, investors can insure themselves against losses. As with many other types of insurance, it's not easy for the buyer to accurately assess the risk but unlike with other insurance, it is also difficult to work out the price that is being paid for the protection.
Most financial advice is based on a portfolio approach, for which a key determinant is the client's attitude to risk. I'm not sure that there are any investors who are looking for ways to lose their capital and, essentially, I start from the position that everyone is risk-averse. On the other hand, most investors are keen to access the highest possible returns. Different products will offer a different balance of risk and return, and there is no perfect solution that can generate higher returns without introducing risk.
Attitude to risk is not a single variable that can be measured and plugged into a formula to calculate portfolio construction. People can have different attitudes to risk at different times in their life and will be influenced by their own experiences as well as by family and friends.
If the money is needed for a particular future commitment it may be treated differently to an investment with no specific goal and clients may even feel differently about risk depending on what the source of their money was. Another very important element is the time remaining until the money is needed. An individual could be comfortable with the idea of riding out the fluctuations in the stock market when they have 20 years to retirement but with six or seven years left to go, perhaps they cannot afford to take risks with their nest egg.
Attitude to risk is also heavily influenced by recent stock market movements but there is an obvious danger that confusing hindsight with foresight can lead to illogical conclusions. For example, there appears to be a feeling that structured products are only appropriate to recommend in a bear market and that when stock markets are growing, equities are a better choice.
Almost all structured products are designed to produce a good return only when the underlying markets they are linked to grow. With a few exceptions, the client would be unlikely to get much of a return on their investment in a bear market, whether they invest in equity funds or in structured products.
Most people who invest do so in the belief that over time, the performance of the stock markets will not only be positive but will beat the available deposit or fixed interest yields and there is plenty of historical evidence to support this. The problem is that these long-term trends also include plenty of evidence of short-term fluctuations.
The point of most structured products is the protection they give if you are caught in one of these market falls. While many market commentators are currently more bullish about equities, and despite strong growth in recent years, many stock markets are only now recovering to the levels of five years ago. Losing money on equities is not a definite event any more than it's definite you'll need to claim on your house contents insurance but it is a very real risk and one for which the available insurance options shouldn't be ignored.
Counting the cost
So what is the real price of protection? Investors in structured products do not usually benefit fully from reinvested dividends, which make up part of the total equity yield. Some may argue that the lack of dividend yield is too great a price to pay but that is an incomplete analysis that ignores the fees charged for other investments.
The structured product example in the comparison of returns in the table uses a four-index basket of the FTSE 100, the Swiss Market Index, the S&P 500 and the Nikkei 225. The equity fund fees are the mean charges of all the funds listed by the UK's Investment Management Association web site in the 'cautious managed' sector, which has chosen an equity investment option with a similar risk profile. A 7% growth rate has been chosen, consistent with UK Financial Services Authority illustrations guidelines, and both products have been assumed to generate capital gains for tax purposes, rather than income.
This is a quite simple scenario and obviously different products would give different results. However, I think it clearly illustrates that the net cost of capital protection may be rather less than expected, and in this example is almost negligible.
Reinvested dividend yields do boost the equity fund return but much of the difference is eaten away by fund charges, while advance corporation tax also reduces the efficiency. Even investments held within Sipps or Isas are subject to this tax, which cannot be reclaimed.
Participation rates in excess of 100% also increase the structured product return, effectively giving the investor back some of the dividend yield. The structured product charges are all built into the participation rate, as is the case with most current offers. The market is fiercely competitive and I believe many current products offer very good value.
In the steadily growing market scenario used for this example, the customer would be slightly better off in the equity fund. But given a comparison such as this, I believe many individuals would want to place at least part of their portfolio in the structured product. Of course, the best active manager could generate a higher return but who can say which one that will be?
An alternative comparison is with index tracker funds. The average charges for all tracker funds are 0.98% upfront and 0.9% annual. With lower fees than the managed funds, the tracker will look more favourable and the structured product has an implied cost of protection of 0.56% a year. But in this case, there is no potential for significant outperformance of the index by the equity fund and there is no opportunity for the manager to act to reduce the risks of equity losses.
Part of the price paid for structured products is also represented by the lower liquidity than that of equity funds. While many products still have no access to capital during the fixed investment term, a variety of access options have begun to be available. Many structured products are still not suitable if the client is likely to need access to the funds during the term but many advisers would be unlikely to recommend any form of equity-linked investment if the money cannot be left alone for five years.
It's ironic that while structured products have often been seen as only for inexperienced and unsophisticated investors, there has been growth in enquiries from knowledgeable, higher-net-worth clients. These individuals are not new to investment and are perhaps better able to assess the risk of loss against the cost of protection.
Structured products are transparent in many ways, with explicit investment links and payout formulas. Is it time for the price of protection to be more obvious, so that the balance of risk and return can be more easily assessed?