Shedding an image problem

Structured products are becoming more mainstream as investors warm to their appeal and advisers become more sophisticated and less daunted by their fine print.

Depending on the client’s long-term objectives, structured products can fit neatly into a range of client portfolios — from accumulators to those in transition to retirement. They can add diversification, provide access to previously unattainable markets, control risk through capital protection, deliver tax benefits, provide comfort as markets peak and offer interesting mixes of asset classes, from alternative energies to emerging markets.

Accru Financial Planning director Matthew Kidd said the products were gaining appeal as their mystique was unveiling.

“They were always deemed to be too expensive or complicated to understand, or the fees too embedded or hard to explain,” he said.

“To the credit of the companies involved, they are coming out with products that are easier to understand for advisers and easier to explain to clients.”

Premium Strategic Planning director Andrew Lord agreed they were becoming more mainstream as advisers become more educated.

He said structured products are a difficult investment as they span internally geared funds to warrants and collateralised debt obligations (CDO) to capital protected unlisted trusts. The exposure may then constitute individual shares, indexes or managed funds.

Adding to this, the loans may be in foreign currencies to take advantage of lower rates and up to 100 per cent geared.

But as planners become more sophisticated, these products become more prevalent and add greater value to a client’s portfolio.

“Dealer groups are apprehensive to use these products because they can be complex to understand, so they are typically picked up by the independent groups,” Lord said.

These products will filter down to the larger dealer groups when they receive greater acceptance from advisers and more clients acknowledge their value add, Lord said.

“Greater competitors will then enter this space, as we are now seeing, and margins will begin to come down.”

PDY Partners director Rod Dickinson said there was more client awareness, but not enough to justify calling structured products mainstream. He finds they fit predominantly with high-net-worth and self-employed accumulation clients.

While he liked their flexibility from a wealth accumulation perspective, peace of mind and tax benefits they offer, he said structured products could be expensive. Also, some do not fit well in platforms and some have clumsy administration. Earlier products are being superceded, and he has concerns about the administration of windups.

Utopia Financial Services principal Deborah Whiting is a big fan of capital protected direct share loans for her mostly high-net-income clients.

She said the reason structured products work is the tax advantages. They also enable people to do what they couldn’t do otherwise because of a lack of borrowing capacity.

“To work, the portfolio needs to generate 4 to 5 per cent a year after tax, and I haven’t had an instance where that hasn’t happened in almost 20 years,” she said.

“I like the low net cost, the full franking credits, the diversification benefits and the fact you lock people into a longer timeframe, so they get accustomed to long-term investment. At the end of five years, clients have the option of selling and paying the capital gain, converting to a margin loan, selling it to a self-managed super fund or doing a reverse geared equity.

“What works terribly well is the ‘shandy’ investment, where you take something that is 4 per cent negative and blend it with something 4 or 5 or 6 per cent positively geared, which is out there.”

GHR Financial Planning director Brian Hrnjak also finds plenty of positives, from access to normally unattainable markets to the neat structuring of an attractive, shorter timeframe with the capital protection element.

He also believes structured products are becoming more accepted.

Even though derivatives remain complex for the average investor, these products are bridging the gap. By being neatly packaged they are more palatable, and the capital guarantee means clients won’t lose their money.

“They are picking themes that are striking appeal with investors,” he said.

“Some have strong environmental themes, emerging market themes and resources themes. They give investors access; they can control risk and they present a value proposition that is attractive. Investors feel more comfortable with these types of products as markets peak. Combine that with gearing and you have an investment platform which produces tax benefits.”

There is also risk control.

“We can quantify the downside risk,” he said.

“If you went into shares or managed funds, the downside could be unlimited. These products give them comfort, but that comfort comes at a price with the fees and derivatives that are built into the product. They appeal more to volatile markets than other types of products.”

Hrnjak has found structured products fit in a variety of places in his clients’ portfolios. They suit accumulators who are seeking alternative ways of accessing different markets, such as international shares, or the more trendy themes of water utilities, water rights, alternative energy and international shares in the emerging markets of China and India.

Hrnjak believes structured products also have a role in the transition to pension phase, where a deferred payment structure means the end benefit will be received in the tax-free pension environment.

The other fit is non-super, where clients use them as a geared investment.

For Gigfish principal Brett Fisher, it really depends on the individual. He finds structured products suit clients who have yet to establish a sizeable net asset position, but have been focused on property. They may be more risk-averse in terms of share market fluctuations and like to sleep at night and not worry about their finances.

“It is like a stepping stone for a lot of novice investors into the share market and gives them an opportunity to diversify into other asset classes that wouldn’t normally be part of their portfolio,” Fisher said.

“Structured products can also fit high-net-worth clients and high income clients looking to maximise tax savings by prepaying interest, adding some diversification into their portfolio and using their excess cash flow.”

For those who don’t have $100,000 in spare cash, it gives them the opportunity to diversify their asset base by borrowing money against their higher income.

“It’s more a product for higher income earners,” Fisher added.

“It’s not something you would recommend for the $50,000 salaried employee because of the cost of funds and the fact you are not getting the tax benefit of interest deduction.”

High-income earners can use the income cash flow savings to diversify their asset portfolio while the actual interest costs are reduced by some tax savings incurred on the deductibility of interest.

Structured products also sit well in a self-managed super fund (SMSF).

“It can’t borrow into these structured products, but it does provide some SMSFs with some international exposure into different investments that have a long-term growth plan that are still capital guaranteed. So they have got no real risk of losing the funds they have accumulated into the SMSF, whereas typical managed funds do have the risk of capital loss.”

Fisher likes their access to different markets, ability to leverage and the opportunity to borrow without the risk of margin calls.

GA Financial Services financial planner Daniel Stefanetti said structured products with protected lending have become a key ingredient in clients’ overall investment portfolios.

He sees the protected lending offerings becoming a bigger part of the lending market.

“The products generally have no margin calls, offer 100 per cent lending, 100 per cent capital protection and, in most cases, have the same interest cost as a traditional margin lending loan.

“The products are attractive for investors who do not have the available capital as security for borrowing, or do not wish to use their personal assets as security. Ultimately, these investors are generally more comfortable only exposing their after-tax interest cost for the term of the investment.”

Lord said depending on the structured product, his firm would always opt for 100 per cent geared outside of super and normally not offer the product to retirees. He may recommend partially protected or geared investments in super to gain exposure to specific market areas, such as China, Japan or alternative energy.

Gearing is an added benefit of structured products, according to Hrnjak, provided the underlying product is fundamentally sound.

“With capital protection, you can say your maximised downside risk is the after-tax cost of interest plus the opportunity costs. Internally, they are getting better these days, as product providers are bringing out products that fit within the tax system. There is no doubt they are used more at the year end for tax planning purposes.”

Accru’s Kidd said internal gearing is popular with super funds. Outside of super, these products can be tax effective, provided the investment suits the client’s risk profile.

“You have margin lending, prepaying interest on the loan, you have a lot of fund managers providing their own finance on structured products and lending 100 per cent, and the interest on that is deductible.”

Of course, there are downsides too.

For Hrnjak, complexity is the principal issue followed by uncertainty of the value proposition, particularly if there is something being trialled that is more innovative with tax structuring.

Fees are another concern that need to be taken into account.

Fisher said even though structured products are becoming more popular, the interest costs are still high.

“There are a few managers who are charging too much in terms of their fees,” he cautioned.

“If they want to be competitive, they need to streamline and not take too much cream.

“I haven’t had any bad experiences yet. You really need to research the manager, the staff involved and what they have done in the past.

“One of the most important features is how they are rewarded and what the performance fees are. If the fund is not producing a positive return, and they are still taking a performance fee, I don’t like that, even if they have outperformed the benchmark.”

Jane-Anne Lee is a financial services writer.