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 traditional asset managers, like Perpetual, drive further innovation; and

> retail investors become increasingly aware of the growing number 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 ‘sleepless 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 follows 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 example, where four out of five financial planners see capital protection as one of the building blocks of a sensibly diversified portfolio and regularly recommend 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 products with some level of capital protection.

Product structures have focused on either protected growth or protected income enhancement. Historically, this has been through exposure to traditional equity markets (initially through indices, and more recently through managed funds, including hedge funds). These structures may also offer leveraged returns, sometimes with less than 100 per cent protection.

The emerging trend has been to seek protected exposure to new markets (such as emerging markets and commodities), which is consistent with a global search for new sources of alpha.

In Australia, the unprecedented growth has been dominated by protected lending products, where retail investors have borrowed to invest in a capital protected growth product, a strategy rarely seen in Europe.

New flows into protected 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 second half of 2006.

The growth and difference in usage from Europe can be attributed to:

> lenders willing to offer 100 per cent loan to value ratios against protected products, attracting investors whose relatively low asset base would otherwise limit their gearing capacity;

> high marginal tax rates that make gearing a tax-effective strategy for high income earners; and

> strong Australian equity market performance for the past five years, which makes gearing all the more attractive.

Even though the market has expanded, Australians hold less than 1 per cent of their portfolio in capital 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 environment;

> clients who have focused on property and who are risk averse about share market fluctuations;

> higher-net-worth clients seeking to maximise tax savings by pre-paying interest; and

> to those who lack discretionary 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 products 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 restructuring the returns from a protected leveraged basket of stocks to deliver an income stream rather than capital growth. This may also be combined with a form of ‘insurance’ to create a longevity product that protects an investor who may otherwise outlive their current level of income and assets.

There may also be greater demand for combined 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 protected or protected unless there is a fall greater than a certain percentage may have increasing appeal.

Capital protected products 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 important 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 challenging 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 another way of providing clients with peace of mind.

All these factors should translate into strong future growth for capital protected products. Protected lending will remain healthy, but demand for other types of capital protected products (such as those used more often in Europe) is forecast to grow over time.

Having established that a certain type of capital protected product makes sense for a particular investor’s portfolio, it’s critical to assess both the underlying investment and the structure when selecting the best available product.

The underlying investment will determine if the investment is successful or not.

Unfortunately, a good structure can’t fix a bad investment. A good structure can significantly enhance a good investment (and increase its relevance 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 difficult to assess the true cost as fees can be structured in many different ways.

Most structured products include both implicit and explicit fees.

Implicit fees are often hidden in derivative instruments that are embedded into the structured product.

The only way to determine the exact level of implicit fees or ‘profit margin’ is to value the underlying instrument on fair market value.

As the derivative instruments 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 expected 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 proportion of the portfolio invested in the risky asset and one on the proportion invested in the risk-less asset. Because the portfolio allocation between the risky asset and risk-less asset is continually changing, 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 providing Monte Carlo simulations 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 successfully meeting their investment objectives.

Russell Chesler is Product Structurer with Perpetual .