The appeal of structure

In recent times, the risk premium for investors who had been willing to take on exposure to riskier assets had reduced so much in some cases they found they had under-priced the risk of a bad event occurring.

Investors are seeking a safer haven, which is translating into an increase in appeal for structured products.

That’s understandable when you consider that, depending on their structure, these products can not only give exposure to markets that can be difficult to invest in, but also offer principal protection.

The latter is the real attraction after such sudden and surprising market volatility, for the minimum you’ll get back at maturity is the amount you have invested.

This is one of the bonuses of a capital-protected structured product. No matter how badly the asset is performing, investors do not have to worry about losing their money. That message has been given new life since August.

Of course, markets work in cycles and there are times when investments do not perform as well as expected.

However, no one really saw the full extent of the credit market correction. Global experts were caught offguard and alarm bells sounded across the world of institutional and retail investors.

The August event served to rouse people from their comfort zone. It was a painful reminder that if there are risks with an investment, investors need to understand and be comfortable with those risks.

If they are concerned about the potential for losses, then an alternative investment offering a form of capital protection should be considered.

Following the credit crunch it was expected that more money would flow into structured products. A large amount had been invested in credit chasing a high yield.

As the turmoil unravelled, much of the money that would have normally been invested in these markets started looking for a new home.

Structured products were seen as the solution.

But what was unexpected was just how much would start flowing into this arena.

Many of the larger financial planning groups are seeing not only a big increase in enquiries, but also in the uptake of structured investments from clients concerned about protecting their capital, particularly those approaching retirement or already retired.

Structured products as a form of investment have been steadily growing in appeal in Australia. Structured product sales to Australian retail investors are set to double this year, with about $3 billion in sales expected by the end of 2007.

In the past two years there has been a solid increase in the quality of products sold to the market, with the key drivers being better product innovation and adviser education.

These products provide many benefits, from geographic and asset diversification in a range of previously unattainable markets to higher growth potential. They can offer tax benefits and, of course, help control risk through capital protection.

When you invest in an asset like a share, an investment property or an emerging markets index, the value of your investment will move by the same percentage as the underlying asset. If the asset rises 10 per cent, then the value of your investment rises 10 per cent. When the asset drops by 10 per cent, then your investment drops by that amount. It is linear.

But with structured products we can create different payoffs that provide a non-linear exposure. The product can be created to provide enhanced growth, income or a combination of both. You can have products with internal gearing that give a larger exposure during good times and less exposure when the asset is underperforming.

One of the most attractive benefits is that structured products offer exposure to an exciting range of asset classes, most of which are equity-related.

Within equities, there are numerous themes.

For example, within international equities there could be exposure to alternative energy, agriculture or emerging markets.

As with any investment, when investors are looking to buy a structured product, they have to want exposure to the asset underlying the structured product.

Next, they have to be comfortable with the structure. It is the structure that determines the type of return, either as growth, income or both.

The key for product issuers is to get the theme right. We then need to develop the best structure to suit the underlying theme and make the overall product fit within the requirements and risk profile of our investors.

By giving exposure to many varied asset classes, we allow investors the ability to easily diversify their portfolio.

Currently, the average Australian investor owns their house and a portfolio of Australian equities, with perhaps some offshore managed funds. They tend to be under-invested internationally, largely because they don’t understand other markets. They regard them as riskier.

If we can create a structure where investors can’t lose their money and provides the freedom and flexibility to invest in a wide range of markets, this allows investors the benefits of geographic and asset diversification in a secure manner.

It will also be an easier way for investors to obtain this much-needed exposure.

It is currently difficult for retail investors to invest in countries such as Taiwan, Japan, Korea and Eastern Europe. By creating these products we can offer a simple way to invest in these markets and remove the currency risk.

These diverse asset classes can also offer the possibility of stronger growth than that offered by Australian markets.

Some of the structures provide internal gearing. If investors can invest in a fast-growing market with the addition of internal gearing, then the potential for significant capital growth is very high.

So who are the sorts of people driving the appeal for structured products?

We find that they tend to fall into two main camps.

First, there are those on a high income who may have an insufficient asset base and need to try to grow their wealth in the accumulation phase. They can afford to gear up to buy these products, often borrowing 100 per cent in a tax-efficient manner.

Second, there are the superannuation clients who wish to continue to invest in growth markets but cannot afford to lose any money. As they are approaching retirement they need to de-risk. Through capital protection, these superannuation investors can continue their exposure to markets that are riskier but have the potential for higher growth without losing their money.

As I said earlier, the continued appeal and penetration of this form of investment will need to be driven by product innovation and adviser/client education. All product issuers are making big efforts on the education front.

Continually, the quality, simplicity and variety of structured products in the Australian market are improving. Issuers have provided high quality products and price tension is boosting their appeal.

This August credit squeeze is only serving to increase the profile of structured products.

Risk is rising on wary investors’ minds, resulting in a groundswell of interest in structured products offering diversification, growth potential and, importantly, capital protection.

David Jones-Prichard is vice president of equity derivatives and structured products at JPMorgan.