May 2007: Structured products set to sizzle

Historically, the term ‘structured products’ was used to describe any non-vanilla equity or debt instrument that often delivered some tax benefit.

More recently, at least as far as retail investors are concerned, it has come to mean a class of products that:

> delivers a synthetic exposure to an asset or basket of assets, which are often internally geared and in most cases offers some level of capital protection; or

> provides leverage for the investor’s choice of underlying asset where the investor could otherwise not borrow (super funds) or seeks some level of downside protection built in.

The first category of products can be considered as ‘investment products’ and need to be analysed as would any investment. The second category of products is ‘funding products’ and therefore need to be analysed (separately to the underlying asset selection decision) as would any loan.

Australian investors are significantly underweight in these products compared with their Asian and European counterparts.

In part this can be attributed to low levels of awareness and understanding among advisers and investors, this in turn can be blamed on manufacturers, which have done a generally poor job of simplifying the documentation.

Despite this, the market is currently in excess of $6 billion and growing at $1.5 billion per annum. However, this is still less than 1 per cent of the total investment assets in Australia. There is scope for this to more than quadruple in the next five years.

More significant, however, in driving uptake is the tendency for advisers and researchers to lump all of these products together as ‘structured products’ and include them in the alternatives category along with hedge funds, which is usually limited to 5 per cent of retail portfolios.

We believe that it is more appropriate from an asset allocation perspective to include them where you would include a direct investment in the underlying asset.

Investment products

These products were initially offered only to sophisticated investors.

However, in an arms race-style frenzy of innovation, product manufacturers have delivered ever more complex products to an often poorly educated retail investor base, seduced by the offer of 100 per cent geared, capital guaranteed investments.

It appears that in many cases, the portfolio construction implications of the underlying asset and the required investment time horizon have been overlooked in the focus on the sizzle of the structure.

As the industry has matured, it is now time to focus on the solution rather than the structure. The questions to be asked by an investor and their adviser should be about:

> where this asset fits in my portfolio?

> what will the impact of the gearing be?

> what is my tax outcome?

> is the time horizon appropriate to this asset or is it more driven by the period required to deliver the capital guarantee? and

> is this the most efficient way to invest in this asset class?

As a general guide, structured products deliver an ideal way to take relatively large risk controlled positions on particular geographic regions or asset classes or directional or spread positions on indices, credit, commodities or interest rates.

In order to understand this positioning in an investor’s portfolio, it is important to understand the basic building blocks of the products and how they interact in delivering the overall investment outcome.

The main building blocks are:

> the underlying asset;

> the legal structure;

> capital protection;

> leverage;

> participation; and

> the payoff profile.

These attributes are interdependent. Generally this means that varying one attribute will enable potentially better results elsewhere.

For example by reducing the level of capital protection from 100 per cent to 90 per cent an investor may achieve a greater level of participation, a shorter capital protected term or a higher coupon.

Underlying asset

The greatest level of diversity is in the underlying asset. Investors can choose from a variety of asset classes (equities, interest rates, funds, credit, commodities and currencies) and a range of indices, regions and markets.

Recently there has been a lot of interest in structures based on underlying funds or actively managed indices (in effect a virtual fund).

Accordingly, the first call an investor needs to make is the asset to which exposure is desired and the direction of the play (bullish, bearish or relative value).

Structure

There are four main structures in use in Australia: structured notes; managed investment schemes (trusts); redeemable preference shares (RPS); and deferred purchase agreements (DPA).

Apart from the taxation outcome, there is little to choose from an investor perspective.

Notes and RPS will generally provide investors with a revenue gain, while DPAs and some trust structures can deliver a capital gain that may attract concessional tax treatment depending on the investor’s personal circumstances.

An emerging variant on the trust structure is to use a total return swap within the trust. This delivers capitla gains tax (CGT) treatment and is a relatively straightforward structure to explain to retail investors.

DPAs on the other hand are more complex to explain to investors and have in recent times come under scrutiny by the Australian Taxation Office (ATO).

Their tax treatment may be impacted by the new TOFA (Taxation of Financial Arrangements) provisions.

Capital protection

Capital protection can be provided by a number of techniques, the most common of which are:

> purchase of a zero coupon bond;

> constant proportion portfolio insurance (CPPI); or

> purchase of hedges (put options).

Historically, capital protection was constructed based on 100 per cent of the initial investment. Investors now have choice as to the level of protection, generally between 80 per cent and 110 per cent.

Zero Coupon Bond: Traditionally the most common approach has been to invest part of the investor’s funds in a riskless asset (such as a Government bond) that will mature at the capital protection date at a value equal to the initial investment amount.

This worked well when interest rates were higher and before the introduction of accruals-based taxation. Falling interest rates increase either the required term or the proportion of the investment that must be dedicated to protection and so reduces the amount invested in the selected asset.

Today, seven-year protection can require 60 per cent of the investment to be dedicated to funding the protection.

CPPI: This is growing in popularity as a result of falling interest rates and provides greater efficiency. CPPI works by dynamically allocating the investment between the riskless asset and the real (but risky) asset. The value of the investment is constantly monitored to ensure there is always sufficient value (the threshold) to acquire a riskless asset that will mature on the capital protection date at the value of the initial investment. This amount increases as the term of the investment progresses leaving less time for growth in the riskless asset.

There are two key risks in using this approach:

> the market in the underlying asset may ‘gap down’ or drop rapidly without allowing the manager time to convert to cash before the value falls through the threshold. The CPPI manager will generally take this risk.

> if the value of the investment falls to the threshold at anytime during the period, the entire amount of the investment will be transferred to the riskless asset. Consequently, the investor will no longer have an exposure to the desired asset.

When coupled with dynamic gearing, CPPI can provide an enhanced level of exposure to the underlying asset and provides the best results for investments in low volatility assets.

Derivatives: The third approach to capital protection is to invest part of the investment in a derivative such as a put option that will allow the manager to exit the investment at the initial investment amount regardless of what may happen to the underlying investment.

For example, a five-year investment in BHP shares could be hedged by acquiring a combination of BHP shares and BHP put options. This is best suited to long-dated positions in liquid assets. This is more common in the funding products discussed below where the cost of the put can be built into the interest rate.

Leverage

Leverage is the amount of debt that is added to the investment to gain exposure to the underlying asset.

Leverage is generally dynamically managed; the quantum of debt being set based on a multiple of the excess of asset value (NAV) over the CPPI threshold or of the residual after setting aside the funding for the zero coupon bond.

The typical range of multiples is three to six. Accordingly, at the outset of a seven-year investment where the threshold is 60 per cent and using a multiple of four, an investor would get an initial exposure of 160 per cent (four times 100 per cent less 60 per cent).

In a CPPI structure, as the excess of NAV over the threshold rises additional debt is included; alternatively, as the excess of NAV over the threshold falls, debt must be retired by selling the underlying assets. This means the manager will sell as the price falls and buys as the price rises. Such a structure will therefore outperform on a trending market, but underperform in a volatile market.

Participation

Participation is the level of return to the investor for a given change in the value of the underlying assets. It is closely related to gearing and the structure used to provide the capital protection.

With the zero coupon structure, the participation is a function of the proportion of the initial investment allocated to the zero coupon bond and the gearing available and is fixed. Consequently, an investor knows precisely the level of exposure at the outset.

With CPPI, however, participation will vary over time and only the initial participation is known at the outset. Neither is intrinsically better; rather investors just need to understand the difference.

Payoff profile

The payoff profile is where the creativity of the providers can really shine through. The main profiles in the Australian market are seen in Table 1 of technical adviser May 2007 issue on page 14.

Choice of payoff profile is inextricably linked to the investors view on the underlying assets.

Funding products

These products provide leverage, capital protection and investment in a single package and are especially useful for investors seeking capital protected (non recourse) funding or are otherwise prohibited from borrowing (such as self-managed super funds). These fall broadly into two categories.

Firstly, those that consist of a loan with a built-in derivative such as protected equity loans, zero cost collars as well as an increasing number of tailored products aimed at executives with large holdings in their employer.

Secondly, structures that are not characterised as loans but provide the benefits of gearing, which are specially suited to self-managed super funds. These include instalment and endowment warrants over specific stocks or indices as well as the new generation products that behave more like margin loans and provide flexibility in trading the underlying asset.

Initially these products were available only for listed equities because of the relatively deep market for options on these stocks. More recently, products have been made available for commercial real estate and managed funds.

In general, these products provide investors with a relatively low risk means of taking significant positions with tax benefits without having to fund the investment from their own resources. This has particular application in the wealth accumulator market where investors have relatively high income but little free cash and relatively high non-deductible housing debt.

Opportunities

Structured products can provide an excellent opportunity for investors to gain exposure to specific sectors, asset classes or regions in a leveraged and capital protected environment or to fund investments they otherwise may not be able to make.

They can also, contrary to widespread perceptions, provide a cost-effective vehicle for retail investors to access less common asset classes or markets. In particular, this is the case for emerging market equities and for credit. An investor seeking to replicate this exposure outside of the structure would be faced with significant additional costs in fund management fees and cost of leverage and hedging.

It is critical for investors to understand the assets and payoff profiles they are investing in and the place that should occupy in their portfolio.

It is also important not to lump all such structures together into the generic alternative investment allocation but to consider where the underlying assets fit.

As structures and documentation is simplified and better understood by advisers and investors, the sector should grow strongly in Australia.

Vince Scully is CEO of boutique financial services provider Calliva, which recently launched its first structured funding product — Calliva SuperAccess.