May 2007: Structured products: the comfort of capital protection

If the European experience is

any guide, the growth of

structured product offerings

in Australia is set for a sustained

expansionary phase.

This growth is expected as

investors:

> take comfort in the concept

of capital protection (but want

more than a cash return);

> the products become more

mainstream;

> new players such as tradition

al asset managers, like Perpetu

al, drive further innovation; and

> retail investors become increas

ingly aware of the growing num

ber of alternatives to traditional,

long-only equity products.

Increasingly, the message to

advisers from investors is that

these products help improve

their ability to achieve their

investment goals.

Tax-effective strategies

remain very important, even

with the reduction in marginal

tax rates.

Australian marginal tax rates

are considered high by world

standards and on the positive

side the reduction in marginal

tax rates has increased the level

of free cash flow available for

investments and to service debt.

Investors are happy to

explore newer asset classes in

the chase for higher returns and

to boost income to support their

retirement plans.

Capital protection is a good

option as it minimises the ‘sleep

less night’ factor, especially for

those with strong recollections

of the 1997 Asian market crash and who are apprehensive

about the current state of

global markets.

The structured product

expansion in Australia fol

lows a rise in popularity

in Europe, the leading

market for these vehicles.

Net inflows in Europe

have grown at 25 per cent

per year for the past three

years.

Take the UK, for exam

ple, where four out of five

financial planners see cap

ital protection as one of

the building blocks of a

sensibly diversified port

folio and regularly rec

ommend these types of

products.

In Germany, a retail

investor can buy a capital

protected product from

their local post office

(which also provides

banking services), while in

Switzerland, a typical

affluent client holds

between 5 and 10 per cent

of their portfolio in prod

ucts with some level of

capital protection.

Product structures have

focused on either protect

ed growth or protected

income enhancement. His

torically, this has been

through exposure to tra

ditional equity markets

(initially through indices,

and more recently through

managed funds, including

hedge funds). These struc

tures may also offer lever

aged returns, sometimes

with less than 100 per

cent protection.

The emerging trend has

been to seek protected expo

sure to new markets (such

as emerging markets and

commodities), which is con

sistent with a global search

for new sources of alpha.

In Australia, the

unprecedented growth has

been dominated by pro

tected lending products,

where retail investors have

borrowed to invest in a

capital protected growth

product, a strategy rarely

seen in Europe.

New flows into protect

ed lending managed fund

products from March to

June 2006, were more

than $1 billion, with many

issuers raising more than

double their targets. This

trend continued in the sec

ond half of 2006.

The growth and differ

ence in usage from Europe

can be attributed to:

> lenders willing to

offer 100 per cent loan to

value ratios against pro

tected products, attracting

investors whose relatively

low asset base would oth

erwise limit their gearing

capacity;

> high marginal tax

rates that make gearing a

tax-effective strategy for

high income earners; and

> strong Australian

equity market perform

ance for the past five

years, which makes gear

ing all the more attractive.

Even though the market

has expanded, Australians

hold less than 1 per cent

of their portfolio in capi

tal protected products,

well short of the 5 to 10

per cent level held by their

European counterparts.

We believe further

growth will be driven by

an increasing awareness

that capital protection is

generally relevant for most

investors’ portfolios.

Capital protection is

especially suited to:

> the self-managed

superannuation fund envi

ronment;

> clients who have

focused on property and

who are risk averse about

share market fluctuations;

> higher-net-worth

clients seeking to max

imise tax savings by pre-

paying interest; and

> to those who lack dis

cretionary cash but want

to gain opportunities by

borrowing without risk of

margin calls.

Protected lending will

continue to be seen as a

sound strategy for the

right investor.

However, as sentiment is

changing, it is possible that

the underlying assets used

for protected lending prod

ucts may shift away from

Australian equities over the

next five to seven years.

Alternatively, investors

and advisers may prefer

leverage within a structure

as the means of increasing

return potential to a less

volatile asset class (such as

hedge funds).

Greater focus will be

on an increased use of

protection and structures

to repackage returns

from any asset class in

the form of income (not

just traditional income

asset classes).

An example is restruc

turing the returns from a

protected leveraged bas

ket of stocks to deliver an

income stream rather than

capital growth. This may

also be combined with a

form of ‘insurance’ to cre

ate a longevity product

that protects an investor

who may otherwise out

live their current level of

income and assets.

There may also be

greater demand for com

bined protection and

leverage structures that

allow investors to access

newer sources of alpha in

a way that better suits

their risk profile.

For example, some

investors may want to be

protected but be happy to

trade off some protection

for higher returns.

Products that are either

less than 100 per cent pro

tected or protected unless

there is a fall greater than

a certain percentage may

have increasing appeal.

Capital protected prod

ucts can also add value to

advisers.

Those currently using

capital protected products

explain they need to

search for new sources of

alpha to help their clients

meet their goals.

There is also a need for

new products to attract

and profitably service the

emerging wealthy — new

segments that are impor

tant as advice businesses

seek to grow further.

Simplification of super

legislation has increased

the importance of finding

new ways to attract and

service the ever-growing

retiree segment. This

includes meeting their

need for income (ideally

for their remaining life),

which has been challeng

ing given insufficient super

savings for many.

Poor performance and

sometimes inappropriate

use of high risk strategies,

such as certain mezzanine

mortgage funds, has

heightened the need for

both advisers and

investors to understand

risk-adjusted returns, with

capital protection anoth

er way of providing clients

with peace of mind.

All these factors should

translate into strong

future growth for capital

protected products. Pro

tected lending will remain

healthy, but demand for

other types of capital pro

tected products (such as

those used more often in

Europe) is forecast to

grow over time.

Having established that

a certain type of capital pro

tected product makes sense

for a particular investor’s

portfolio, it’s critical to

assess both the underlying

investment and the struc

ture when selecting the best

available product.

The underlying invest

ment will determine if the

investment is successful or

not.

Unfortunately, a good

structure can’t fix a bad

investment. A good struc

ture can significantly

enhance a good invest

ment (and increase its rel

evance for certain types of

investors).

A bad structure, on the

other hand, can seriously

harm a good investment.

The structure changes the

risk/return profile of the

underlying investment, so

it’s important to understand

how different features

impact risk and return in

different scenarios.

Fees are obviously

important. It’s often diffi

cult to assess the true cost

as fees can be structured

in many different ways.

Most structured prod

ucts include both implicit

and explicit fees.

Implicit fees are often

hidden in derivative

instruments that are

embedded into the struc

tured product.

The only way to deter

mine the exact level of

implicit fees or ‘profit

margin’ is to value the

underlying instrument on

fair market value.

As the derivative instru

ments in many structured

products are complex and

‘exotic’, they are difficult

to value unless you have

access to complicated

mathematical models.

Even the impact of

explicit fees on the expect

ed investor outcome can

be difficult to assess.

For example, there can

be a single management fee

charged on the value of the

portfolio or there could be

two fees, one on the pro

portion of the portfolio

invested in the risky asset

and one on the proportion

invested in the risk-less

asset. Because the portfo

lio allocation between the

risky asset and risk-less

asset is continually chang

ing, the percentage fee that

would be paid each year

will change.

The impact of fees will

clearly vary depending on

how they are structured.

This is definitely an area

where the research houses

can add value. Over the

past few years they have

‘resourced up’ and some

researchers are now

including an assessment of

the implicit fees and pro

viding Monte Carlo sim

ulations that provide a

clearer picture of the

expected outcomes under

different scenarios.

With the size of the

structured product market

continuing to increase, this

trend should continue.

At the end of the day, a

well-structured product is

one that gives investors

the best chance of suc

cessfully meeting their

investment objectives.

Russell Chesler is Product

Structurer with Perpetual .