May 2007: Structured products: the next generation

Structured products are rapidly finding a home in direct portfolios and self-managed superannuation funds because of their unique ability to provide access to emerging investment themes.

In the past 12 months, structured products have undergone an evolution. Once perceived as complex and expensive, structured products today are far more affordable and simple to understand.

Underlying investment themes

As the requirement grows to diversify away from maintaining a strong bias towards Australian shares, investors are turning to structured products as an efficient and simple way to access new markets and new investment themes.

Structured product providers are able to move far more quickly than traditional fund managers when it comes to manufacturing, and so naturally, structured products are providing the first access point to emerging themes. With no requirement to choose between fund managers and different investment styles, structured products are pure ‘beta’ plays on the performance of an underlying market.

Take water for example, Australian investors have been aware of the demand for water for some time now. Until three months ago there was no way for investors to benefit from the global demand for water utilities.

Since March, two new structured products have come to market that allow Australian investors to access the global demand for water utilities.

This is a pure access play for investors — exposure to the performance of a global basket of water-related listed companies — unlike the traditional investment management space, there is no demand on advisers to pick a fund manager who will outperform an index, or generate ‘alpha’.

Emerging markets is another theme well serviced by the structured products providers.

There is a sense of urgency around getting exposure to global emerging markets. However, the choice of fund managers accessing emerging markets is very small, and there has been little fund research conducted to support them. Again, the structured product providers have designed simple access products that provided beta exposure to either the emerging markets of Brazil, Russia, India and China, commonly referred to as the ‘BRIC’ economies, or more tailored exposure to the largest emerging markets: China and India. Investors are able to gain exposure to the beta in these markets, simply and efficiently, and importantly, without currency risk.

Investors don’t go looking for structured products, in the same way they don’t go looking for a managed fund or a listed share.

What they are looking for are opportunities to access an investment idea, be it a geographic region such as Asia and emerging markets, or a specific asset such as the current popular ‘water’ theme.

The cost benefit on capital protection

Structured products provide features that more traditional investments are unable to provide.

The primary differentiator of structured products from traditional investment vehicles is the ability to offer a degree of capital protection. Capital protection, similar to insurance, once seen as an expensive ‘nice to have’, has become more affordable, and is now a critical component for investors accessing new markets, especially if the term of this investment is less than five years.

Many years ago, but still long enough for some participants to remember, capital protection had a bad reputation.

Up until the late 1990s, when the Australian share market was far more volatile than it is today, investors enquired frequently about capital protection. However, they were deterred by the prohibitive costs.

The original capital protected structured product used single stock put options to provide protection.

The cost of a put option is dependent on five factors: the strike price — the level of protection; term of the option — when protection was required; dividends; interest rates; and the volatility of the underlying investment.

The more volatile the underlying investment and the longer the term to maturity of the option, the more protection costs.

So, in the case where an investor wanted to protect a position in BHP for a one-year term, the cost could be upwards of 10 per cent. In this scenario, most investors preferred to take the risk.

Each year at the end of the financial year, there was strong demand for protected share portfolios from investors who looked at protected lending as a way to prepay deductible interest.

However, when in some instances the interest and insurance cost of these investments hit the 15 per cent mark and after the landmark Firth versus ATO (Australian Taxation Office) case, the ATO introduced new guidelines to ensure that deductions were only allowed for the interest component of the investment, and put options and other non-interest costs formed part of the investor’s cost base.

The new generation of structured products use zero coupon bonds to provide protection and a call option to provide exposure to the underlying investment.

In a low interest rate environment, less money is needed to be allocated to bonds for protection, leaving more to allocate to call options to gain exposure.

For example, the cost of a $100, three-year, zero coupon bond today is around $82.50. From a $100 investment in a structured product, $82.50 is allocated to the bond, which will grow to $100, ensuring capital protection, and the residual can be used to purchase call options to provide exposure to the underlying investment.

The trend to less than 100 per cent protection and more than 100 per cent exposure

The less capital protection required the more money available to provide exposure to the underlying investment. Many investors are now electing to reduce the level of capital protection in order to enhance their exposure to the underlying investment.

Extending the example above, if the investor only requires 90 per cent protection, the cost of the bond is $74.20, leaving more to invest in call options over the underlying investment.

The cost of the call options in this example is a function of the same variables as the cost of a put option given above.

However, the most important variable is the volatility of the underlying investment. Exposure to emerging markets, or a single Asian market, would be more expensive than exposure to the Australian share market.

Since diversification reduces risk, that is, volatility, the ability to add different underlying investments to the reference basket, may help to reduce the overall cost of the exposure.

However, one must be careful that underlying investments aren’t being bundled together for a pure diversification sake, and that the structured product remains true to the original investment theme.

In a recent example of a structured product offered in the Australia, investors were given the option of choosing either 90 per cent or 100 per cent protection.

The difference in the exposure to the underlying investment these alternatives provided was indicatively given as 130 per cent or 100 per cent. That is, if an investor was prepared to risk 10 per cent of their capital, they could gain exposure to 130 per cent in the growth in the underlying investment. This exposure level is known as the ‘participation rate’ and reflects the amount of exposure to the growth in the underlying investment that an investor is entitled to receive.

Investment horizons

In a soon to be released survey into alternative investments conducted by Investment Trends, investors were found to have a preference for capital protected investment terms of less than five years.

In the past, structured products, particularly those providing access to hedge fund investments, had terms from seven years to 10 years.

Today, the shortest term structured product investors can buy off the shelf is three years. Most would classify this as medium term.

The importance of the term is that structured products are like closed end funds. All investors get in at the same price on the same date, and if they want the benefit of capital protection, exit on the same maturity date.

Generally, investors are not locked into these investments. Product providers offer liquidity, in most cases monthly, allowing investors to exit early if required.

Profit lock-ins

Given the short-term volatility in markets, shorter-term products heighten the necessity for capital protection, and for the ability to lock in profits. Profit lock-ins is another innovation available only via structured products.

By observing the performance of the underlying investment on a periodic basis, say quarterly, rather than only at maturity, structured products allow investors to benefit from price movements throughout the investment term.

The investor is entitled to the quarterly average growth in the underlying investment, rather than only the point-to-point growth in the underlying investment.

This protects the investor from ‘tail risk’, that is, the risk that after making good gains early in the investment term, as the maturity date approaches, the investment falls below its initial value.

This feature can be enhanced further by using the ‘floored average’ mechanism, which works to protect the investor from negative performance of the underlying asset by ‘zeroing out’ any falls below its initial value. This ensures that once gains are locked in they cannot be given back.

‘Quarterly averaging’ and ‘zeroing out’ are technical terms. By providing them as a feature of structured products, investors can be assured not only of capital protection, but a greater probability of making a return from their investment.

In the instance where an underlying investment performs strongly and consistently throughout the life of the structured products, quarterly averaging and profit lock-ins will detract from absolute performance (see graph 1, on page 5, May edition of Technical Adviser).

The tools of the trade

The above discussion shows that there are a number of levers available to the structured product provider to meet the demands of investors.

In summary they are:

> choice of underlying investment exposure;

> degree of capital protection;

> investment term; and

> performance observation points.

The output from these decisions will be a calculation of the participation rate, meaning what degree of exposure to the underlying investment the investor receives.

Very few investors are prepared to accept less than 100 per cent participation, so terms are lengthened, protection lowered, or more regular performance measures used to increase the level of participation to an acceptable level.

Cost

Structured products have different cost structures to traditional managed funds and so it is hard to line them up for comparison.

Few providers charge establishment or contribution fees. Management costs compared to traditional funds are low. Generally the provider is not actively managing the underlying investment rather the underlying investments are a static index or basket of assets. If the product is offered via a unit trust structure there will be trust fees.

The risk to the provider is in valuing the option used to provide participation in the growth of the underlying investment. This is an ongoing risk that must be managed in the open market. The provider’s skill comes in pricing and managing this risk, and hence this is where their profit margin will generally lie.

Structured products are offered in a highly competitive marketplace and as more providers have entered the market, risk margins are being reduced to highly competitive levels. Investors are the beneficiaries of this environment.

Adviser remuneration may also be embedded in the price of structured products, although the ability to rebate these fees is starting to be introduced to newer structures.

What’s next?

Structured products are an access product, used to gain exposure to new ideas often before the fund managers get around to offering alpha generating product in the same assets or regions. There is a world of opportunity available to Australian investors and advisers who embrace structured products as a useful tool for diversifying investor portfolios and spend the time to understand the variables used to design these innovative solutions.

The challenge for structured providers is to remain relevant by continuing to offer simple solutions, at a reasonable cost that meet the needs of investors.

For many of these providers, who’ve seen the complexity of products that have been offered in offshore markets, there’s a frustration that Australian investors are lagging the demand experienced in Asia for example.

However, as any local financial market participant will warn, the Australian market is different, and the best products are those designed in consultation with investors.

Cathy Kovacs is a division director in Macquarie’s Equity MarketsGroup . The group has been at the forefront of structured product innovation in both the wholesale and retail marketplace for over 10 years. Its most recent innovation is MQ Gateway a structured product designed to allow investors access to a menu of global investment ideas.