Protection against a rainy day

There are very few genuinely new products in financial services. Usually they are variations on an existing theme, and structured products fall very much into this category.

In essence, structured products can be defined as an investment product in a particular sector that is encapsulated with margin lending to provide a degree of certainty on the return. The trouble is that everybody thinks structured products are an entirely new investment class and should therefore be lumped with alternative investments.

Confusion reigns

This generalisation of the products has annoyed the suppliers, confused the researchers, and sent most advisers scurrying away in the opposite direction. Macquarie Margin Lending head of distribution and marketing Steve Robertson says there is a lack of understanding surrounding structured products. “There are not a lot of fund managers that do structured products, it is usually a specialist team that handles them,” he says.

“Structured products combine investment with lending and capital protection. You have got to have at least two of the above before it can be a structured product.”

Robertson says the investment in the product can be a traditional asset class, such as Australian equities, or an unusual asset class, such as commodities.

“Certainly, the products are more complex than the unbundled product, but they are offering a total structured solution,” he says. “You have got a total solution packaged up.”

Demand for commodities

Macquarie Investment Banking executive director Peter Lucas says putting commodities into a structured product has brought a new asset class to retail investors. “The commodities structured product invests in metals, agribusiness and livestock,” he says. “We saw there was a commodity bull-run that tends to last for 15 to 20 years and is substantial.”

Lucas says the demand for commodities continues to grow from countries such as China and India, and it is an asset class that takes a long time to slow down.

“So the question is, how do people get exposure to commodity prices?” he says. “We worked with the Macquarie commodity desk on how investors could get exposure to a diverse range of commodity prices and be 100 per cent protected.”

According to Lucas, the structured product takes a certain amount of risk out of what is a high-risk area. “This means advisers can offer an alternative investment class with capital protection,” he says. “Commodities are a fabulous story and using capital protection through options means investors are going into a reduced position, which means a lot more upside.”

He adds: “One selling point of commodities is that it should be the fourth pillar of an investment strategy.”

However, Lucas says advisers are failing to discuss structured products with their clients.

“Advisers should be looking at underlying assets. With commodities, advisers are not thinking about adding a new asset class to the strategy,” he says. “Still, they have to look at where the asset class sits. If it is a traditional asset class, such as equities, a structured product fits there.”

Deutsche Bank head of retail distribution Paul Banks says while there have been some complicated definitions applied to structured products, in reality they are easy to understand. “Basically, we are looking at a solution with leverage and some form of capital protection attached to a risk asset,” he says. “We are trying to preserve a return in a structure and give a more definite return outcome.”

Banks says people are sometimes concerned about the structured nature of the products, but these are investments that are well-known, such as warrants or hedge funds.

“All a simple leverage structure, such as warrants, is doing is enhancing the return,” he says. “It gives the investment in a structured product a certain outcome.”

Research house reviews

With a history of using capital-guaranteed products in the early ’90s as well as margin lending, Australian investors should have warmed to structured products. But it hasn’t been as simple as that. Capital Guaranteed Investments chief executive Ross Benson says there is definitely a market for these products in Australia, but the choice has been limited.

“There is a strong momentum for issued products, but the big challenge is the education process,” he says.

“You can’t expect the adviser to understand the full structure of the product when researchers are not able to understand the products.”

The problem is that some research houses have lumped structured products in with alternative assets. This has meant the products are being compared with pure hedge funds and other alternative products. The other, more serious, implication of this scenario is that structured products are recommended for an allocation of between 5 to 10 per cent of a portfolio.

“The challenge for advisers is getting research analysts to review structured products properly. Then the products will gain understanding,” Benson says.

He adds: “When research analysts look at a product, they have got to understand that it is about sector allocation. In a structured product the exposure might be to Australian equities. If you don’t understand that situation, then you see it as an alternative investment.”

Benson believes there needs to be a new category for structured products so that like can be compared with like. “What has changed is not the asset class, it is the structure,” he says. “One must understand the structure and which asset class it is in, as the core objective is to provide exposure to that asset class.”

Zenith Investment Partners director David Wright says his research house has seriously studied this new product segment.

“We have spent a lot of time coming up to speed on these products, looking at areas such as the capital guaranteed structure,” he says. “The approach we take to these products is to look at what segment they belong in, with allowances for the various structures used.”

The cost of capital protection

The structure around the products can be expensive, Robertson admits, but it is protecting the client’s capital. “The downside is you pay a higher cost to get the capital protection, which is done through options,” he says. “The client can pay a high cost, but they are getting capital protection, which is different to other products.”

Robertson says the charges in structured products are well disclosed and they are generally targeted at informed investors. “Structured products can be used for high-net-worth executives who have share and options exposure,” he says.

Wright says Zenith is including structured products in model portfolios where appropriate. “We look at the underlying investment and how that fits into a strategy,” he says. “Structured products are an alternative investment in the portfolio allocation. They are not something in the alternative investments segment.”

Wright agrees the cost of protection is high, but in certain model portfolios the client wants the protection while gaining exposure in a higher risk segment such as a hedge fund.

Benson believes structured products provide risk-managed alternatives for advisers to use for their clients, and that the products will evolve as advisers become more comfortable with them.

“It is an evolutionary process and I believe the style of product will change the style of advice the advisers give to clients,” he says. “I think inclusion in the construction of a portfolio will depend on whether the adviser is in favour of strategic allocation.

“Ideally, we want advisers to risk manage solutions.”

Getting dealer group approval

But structured products must be put on approved lists first, which is something that is slow to happen according to Benson. “Financial planners can help by encouraging dealer groups to put them on approved lists,” he says. “But part of the problem for the lack of use [of structured products] is the post-graduate researcher telling advisers whether they can use the product.”

He adds: “However, we do have some experienced advisers who are getting the products into dealer groups.”

Deutsche Bank director retail distribution Greg Hickling says structured products should be part of the advice process.

“Advisers should have a section of the portfolio in structured products when they have a particular asset class on their investment platform,” he says. “It is for the clients who need to have exposure in an asset class, but with capital protection. It comes down to the risk appetite of the client.”

Investor insurance

Hickling says capital protection is a form of insurance for the client, as they no longer have to worry about losing in capital.

Lucas agrees structured products fit into traditional asset classes, with a growing demand for capital protection. “Structured products fit in to a traditional asset class, and lenders can offer 100 per cent capital protection,” he says. “There is a big market for 100 per cent protection.”

Lucas says the products are suitable for younger clients wanting to build their asset base. “When we see investors coming to these products, they are coming for performance at the beginning of their careers,” he says.

“They are looking for that sustained, certain outcome of market exposure.”

Conversely, structured products are also suitable for people at the end of their careers where capital protection is crucial.

“People nearing the end of their working lives want exposure to certain asset classes, but also want their capital protected,” Lucas says.