Structured investments: can improved fee structures boost sentiment?

Changes are afoot in the structured investments arena, with increased transparency and clearer fee structures. But is sentiment changing? Benjamin Levy reports.

Structured products have suffered off the back of the global financial crisis. The sector has been subjected to increased regulatory scrutiny and advisers have even been warned of over-engineered structured products by product providers themselves.

Even without the caution, adviser demand for structured products has fallen drastically, according to some.

Transparency and clear fee structures are the bywords for investors and planners in recent times, and the complexity of structured products is keeping people away. However, there is light at the end of the tunnel, with signs that investor demand for the specialist products is beginning to improve.

Demand

“I’d say the demand for structured products has come off a cliff,” says the managing director of Matrix Planning Solutions, Rick Di Cristoforo.

Advisers are not leaving structured products completely alone because there is a continuing niche need to deliver specialist products to clients, but the level of interest has definitely fallen, he says.

“It’s far more difficult to get access to an underlying investment through a structured product where that access is worthwhile having.

"The range of structured products has been reduced, the gearing is more expensive, tax legislation is marginally better than what it was a year and a half ago but a lot worse than [what] it was three years ago, so there is a whole range of things that are not helping,” Di Cristoforo says.

Vince Scully, principal of Black Wattle Capital, agrees that demand for structured products is lower than it was.

“Given what’s happened in the last few years, I would suggest that demand for these products is materially lower than it was. Go back to June 2007, and you will see that was the peak of demand and supply for these things,” he says.

Product providers are divided on how advisers should approach the sector, with some warning planners off over-engineered structured products.

Tony Rumble, the founder of Alpha Structured Investments, a boutique structured products provider, raised concerns earlier this year about structured products being issued by large institutional asset companies that are so highly engineered it was “hard to understand what was going on”.

Planners were being offered too good to be true features like guaranteed coupons and minimum guaranteed returns that were engineered by product providers to disguise a payment of what is really just the return of an investor’s initial capital, Rumble said.

Rumble also questioned the ability of research houses to properly analyse the specialist products.

“Research houses aren’t equipped to look at all the relevant features of investments, including the tax and regulatory profile of an investment. That is a huge risk for investors,” he said.

However, some product providers have recently urged investors not to abandon structured products because of the fallout from the financial crisis.

JP Morgan's former director of equity derivatives and structured products, David Jones-Prichard, said recently that investor’s preferences for less complicated products carried a risk of losing out on significant share market gains.

“There are a number of more sophisticated investment products in the market that have been developed to meet specific investment needs and then tried and tested to improve delivery of returns,” Jones-Prichard said.

It was “drawing a long bow” to say complicated structured products were to blame for the financial crisis, Di Cristoforo says.

“Ultimately, you had people who were stupid enough to lend money to people who were stupid enough to borrow more than they could afford to repay. Structured products shouldn’t be blamed for that,” he says.

Lonsec’s head of ratings for income and alternative products, Michael Elsworth, believes the government guarantee is one of the factors impacting on the popularity of structured products.

“Volumes are way down from two or three years ago, and that’s in no small part due to the government guaranteed term deposits. They are paying 6 per cent, and the retail market, at least, is still reasonably risk averse, and they need a good reason to move away from that. It’s quite a long hurdle,” he says.

However, there are some signs that investor demand for structured products is returning, according to Macquarie’s specialist investment executive director, Peter van der Westhuyzen.

The popularity of specialist investment products is closely tied to investor sentiment, therefore, as investor sentiment has started to improve in recent months, so has the demand for specialist products such as structured products, Westhuyzen says.

Transparency and fees

At a time when transparency in fee structures is so important for the financial planning industry, structured products start at a disadvantage.

“The problem with structured products is that it’s very difficult to work out what’s going on. Even if you read the Product Disclosure Statement, it’s quite difficult to work out what you’re actually getting.

“When it comes to redemptions, it’s almost impossible to predict what your return will be for a given performance of the underlying asset,” Scully says.

“Secondly, it is impossible to work out what you’re actually paying for the underlying investment because there are so many different places that can leak fees and expenses.”

Transparency here is a key problem, as it is difficult to work out what underlying asset an investor is actually holding and for what cost, Scully adds.

“I would suggest it is impossible for an adviser to work out what a client is actually paying for. How can I, as an adviser, put my hand on my heart and say 'this is what you go through if the market does this’?” he asks.

“There are structuring costs, there are underlying asset costs, there are some protection costs — there is a whole bunch of stuff that’s almost impossible to unpick and say that this is the total cost of holding this product compared to buying the physical underlying,” Scully says.

The popularity of structured products is being hit by the “higher emphasis” on transparency across the industry, according to Di Cristoforo.

“The industry and the profession is moving towards fee transparency and clarity and you have a product at the moment which is quite difficult in terms of its transparency. Not all of them are the same, but it’s difficult to parcel up what you’re paying for,” he says.

The cost of structured products has also risen incredibly, Di Cristoforo says.

“Capital protection has become incredibly expensive and, as a result, the difficulty you have is that at the very time you need your capital protection it’s actually added to most expenses and the balancing act between benefit versus cost is not easy.

"Some of the protections at the moment are in the vicinity of a full lending rate, so you could be paying 10 per cent of the capital value of the portfolio in order to protect it,” he says.

However, Westhuyzen argues that the cost of structured products has fallen.

“It is materially cheaper in the last 12 to 18 months, and that’s really as a result of volatility falling dramatically, and that in itself is feeding through to lower protection costs. [We also] don’t have the funding costs that we used to,” he says.

Some of Macquarie’s capital protection costs can be as low as 1 per cent per annum through to more than 9 per cent, depending on the volatility of the underlying share, Westhuyzen says.

While he would have agreed with Di Cristoforo’s estimates of the costs of capital protection as recently as nine months ago, the pricing he saw in Macquarie’s June product suite survey showed that the cost had fallen dramatically.

Westhuyzen also doesn’t agree that advisers are staying away from structured products. Rather, they are following a three-step process in their approach, he says.

“There’s a very, very clear process that advisers seem to be going through. Firstly, they look at what the underlying investments and exposures are.

"If you go back to 2007, there were a lot of questions about structures and capital protection, and how the products actually worked.

"Then, sitting underneath that, there are a lot of questions about the investment itself. We see a very clear trend where people are focusing very clearly on investments,” he says.

Advisers are incorporating their concerns about the transparency of the product into the third step by delving into worst-case scenarios involving structured products.

These include the consequences of a market fall of 20 or 40 per cent, the ultimate fee structures and how the structure actually works, Westhuyzen says.

“They’re really good questions and it feeds into the need for advisers to understand the transparency of the product,” he says.

Three or four years ago there was a strong reliance on education by product providers and research reports, but dealer groups are now taking the initiative and approaching providers to design education training workshops around different kinds of structured products, different capital protection mechanisms and their performance in different market conditions, according to Westhuyzen.

“They are definitely forming their own views, but they are supplementing that with specific education programs as well,” he says.

However, Scully maintains that understanding all the fees of structured products is the real problem for advisers, not how the product works.

“I’ve been on both the issuer side and the adviser side and I still struggle to work out what exactly is going on.

"I understand how the structure works, and where the costs apply, but I just could not say precisely to a client that if the cost goes from $100 today to $150 in five years time, this is how much money you’ll make,” Scully says.

Despite the effort to educate advisers about structured products, the education of investors is being left behind. No matter how many times it is explained, investors still don’t understand how the product works, Scully says.

“There are three possibilities. Either the client just doesn’t want to know or ignores it; the adviser doesn’t understand or can’t explain it; or the product provider doesn’t explain it. I put it in bold, highlighted, in the prospectus under the risk section. And when something goes wrong, people still ask what happened?"

Disclosure

The Australian Securities and Investments Commission (ASIC) updated its disclosure guidance for capital protected products, including structured products, earlier this year, as it believed some investors may be attracted to capital protected products without fully understanding the inherent risks.

The regulator suggested that product issuers make more effective disclosure by clearly explaining counterparty risk and give investors the ability to assess the likelihood of early termination or other significant limitations.

Issuers should also provide better disclosure costs that may apply if an investor seeks to terminate or redeem a product before its maturity date, ASIC said.

However, despite the update, some commentators still believe the regime falls short.

Part of the problem with the non-transparent nature of structured products is due to the struggle between complex products and the current disclosure regime provided by ASIC, according to Scully.

“The standard Australian Securities and Investments Commission disclosure format and what you have to disclose actually doesn’t deal very well with structured products,” Scully says.

“The thrust of the fee disclosure regime says you need to disclose anything that is debited to the client’s account or is a function of the cost of holding the underlying asset, which you wouldn’t pay if you held the underlying asset directly.

"But what is the underlying asset? It depends on the structure,” he says.

“If you comply with the rules that are there today, I don’t think it really helps a client understand precisely what they’re paying for.

"That’s not to say there is something more that ASIC can or should do, because they are changing the disclosure regime, it’s just that it’s actually a very complicated calculation,” he adds.

The disclosure regime is designed to disclose the cost of the product an investor buys, relative to holding the underlying asset directly, but structured products have another layer of fees between the actual product and the underlying asset, which isn’t caught by the disclosure regime, Scully says.

“It would be difficult to see how you actually could capture that layer without capturing other intermediary costs,” he says.

“For example, if you had an Australian equities fund, it would capture BHP’s internal costs, not just the fund. Once you go below the fund, it starts getting very tricky.”

However, Elsworth believes the disclosure regime is pretty good.

“You can have a level of disclosure that results in a 100-page plus Product Disclosure Statement, [but] is that the sort of level of disclosure that people are after?

"Or are they best served with a two to three-page form that’s far more digestible? As far as the new requirements are concerned, the market is still feeling its way a bit,” he says.

Popularity of different products

As advisers focus on transparency and fees, particular structured products are becoming more popular.

“There’s been a push for more simplistic products that are more transparent, so what investors receive at maturity is a little more transparent in terms of payoffs.

"Therefore, there is less of the CPPI [Constant Proportion Portfolio Insurance] style product, or path dependent structured products, and more products that have defined payoffs at maturity,” Elsworth says.

“Fees are always tricky. In some cases the fees are transparent and in some cases they’re not. For example, the option products lack transparency from a fee point of view, but it’s just the way they are.”

Standard & Poor’s head of structured products Rodney Lay says CPPI structured products have suffered from their associated costs and their performance during the financial crisis.

“CPPI structures have an indirect, implicit cost, and that is if you have less than 100 per cent exposure then your returns are less than the market, so if your exposure has gone down to 80 per cent and the market goes up 10 per cent, you only capture 8 per cent of that.

“The whole point of that is to ensure that if the market goes down enough, your exposure can go down to zero, so that the value of the investment doesn’t go down any further.

"The problem with that is that during the global financial crisis markets went down, but they were also highly volatile. And when you have volatility the structure doesn’t work very well.

“Participation tends to be less than 100 per cent, so it may drop to 80 per cent, it may increase to 85 per cent, it may then drop to 70 per cent. And when it does that you get transactional costs because you have to sell out of the underlying asset and then you have to buy it back.

Because of that advisers don’t really like the structure at the moment,” he says.

Because some structures are cash locked, if an investor ends up having no exposure to the underlying asset, they must wait until the maturity date of their investment to get back their 100 per cent capital protected amount, Lay says.

“That’s the way the structure was meant to work. I think some advisers didn’t understand it fully.”

Capital protection is still important for advisers, and there are a growing number of them to accommodate their needs, according to Westhuyzen.

“The big difference we’ve seen with advisers is that compared to three or four years ago there are different numbers of capital protection structures you can use.

"You can use over the counter options for direct equities, managed funds or bond plus or CPPI, there’s a whole number of them,” Westhuyzen says.

“The level of questions they are getting around how capital protection works for a particular product is very pronounced compared to where it used to be three or four years ago. When the markets fell over the last two years, particularly with products that had CPPI structures, clients invested into cash, so there is a far greater level of awareness of how the capital protection works,” Westhuyzen says.

Portfolios

Structured products should only be used when it would reduce risk on individual highly liquid securities, according to Di Cristoforo.

“Primarily highly liquid equities only, not exotics and derivatives and all these other bits and pieces, because the problem with that is that these are the places where the market breaks down,” he says.

Westhuyzen says they are seeing a very strong focus on Australian equities, particularly allocations to Asia, and increasing requests for index based, or beta driven investment and lower cost structures.

Elsworth says many investors have changed their investment behaviour when it comes to structured products and are dealing in smaller quantities within particular asset classes.

“We’re seeing a lot of smaller transactions that are tailored to a specific positive investment view, whether it be around interest rates or the share market, but they tend not to be the mega-transactions that were done two or three years ago — they are much smaller, in one or two particular groups,” he says.

Lay still recommends capital protection for domestic and international equities, despite the lower returns a portfolio will generate as a result.

“A structured product with capital protection is obviously a risk mitigant; you can obviously go long Australian and international equities, but then you have capital protection below it, so it’s a lower risk strategy, it will be lower risk returns but you will have lower downside risk,” Lay says.

There are many other derivative structures that offer a fixed income amount that can also be used for investors, Lay says.

Those derivative structures will continue offering fixed income amounts unless a particular event, such as a 20 per cent market fall, happens, in which case the fixed income return will be suspended.

“If you take a market view that markets are going to be flat or go up, or they may be volatile, if you already have some money in equities then you should use it as an income aspect. It’s using equity market exposure and translating it into a different payout,” he says.

Lay warns, however, that there is no one size fits all structured product for investors.

“There are a whole different range of payout profiles that will suit different investors and suit different market environments and suit different components of an overall portfolio. Structured products are designed to be an aspect of a broader portfolio,” he says.