Structured products: Proceed with caution

Any adviser with clients approaching retirement age will know too well the pain incurred when markets take a chunk from an investor’s capital. It’s a scenario many would like to avoid facing again, and given the uncertain outlook for both real economies and sharemarkets, is not an unfounded concern.

Many structured investment products promise to reduce this risk, either by offering capital protection or by employing other strategies to alter the return delivered by the underlying investment. But before jumping in, advisers need to consider whether the cost of these products justifies the outcome.

The collapse of complex credit-based structured products was one of the causes of the global financial crisis. Overseas, the resulting regulatory response has slowed the development and uptake of similarly risky products. Locally, the majority of structured products are neither as complex nor credit-focused as their overseas counterparts. But inflows to these products have still been depressed in recent years, according to Adviser Edge head of structured products research, Geoff Watkins. In Watkins’ experience, the take-up in most dealer groups is “still limited”.

“We’ve found a lot of the [structured] products don’t go on general approval for all of the advisers in the group. Instead, the head office at a dealer group level will limit it to special approvals,” Watkins said.

This is likely to be partly because “they’re only getting demand from a few advisers, and on the other hand they want to keep it to a select group of advisers who are more experienced and have more knowledge of [these types of] products”.

Research house Morningstar doesn’t rate structured products — something which could be interpreted as an implicit vote of no-confidence.

Morningstar co-head of research Tim Murphy believes there are “few, if any, structured products that we think have much investment merit”.

“As a general rule of thumb, we tend to think investors are best off investing in transparent, low-cost, easy-to-understand investment vehicles, no matter what the asset class may be,” Murphy said.

“I’m yet to come across a structured product that meets those criteria.”

Furthermore, Murphy believes the majority of structured products are too difficult for advisers to be able to truly understand.

“We would argue that most advisers and investors don’t understand most of these products and therefore shouldn’t be going there.”

Assessing structured products

While structured products do have their critics, there may still be clients for whom they are beneficial and useful. With structured products, advisers must not only assess the underlying investment but the overlying structure as well, including the additional costs created by the particular strategy.

Watkins warns a qualitative assessment based on the underlying investment and additional features offered is simply not enough.

“We find it’s impossible to know what a [particular structured] product is useful for unless you actually run some numbers and test-drive it,” Watkins said.

While advisers may like the investment theory behind a particular structured product, the details of the investment outcome are the key.

“[Advisers] really have to look at the details and run different scenarios,” Watkins said.

“Otherwise you risk believing that it’s more useful in a portfolio than it was.”

A cost analysis is also integral to assessing the suitability of a structured product for a client. Watkins warns that the fees charged in many structured products “aren’t explicit — you don’t actually see what it’s costing”.

For example, where options are used to manipulate returns, it’s not possible to assess whether the product issuer is “paying market price [for that option] or whether they’re putting a big margin on it”.

“Maybe you’re getting a good deal, maybe you’re ripped off, you won’t know,” Watkins said.

“How much they’re making out of it just isn’t completely clear.”

Murphy agrees that transparency of fees can be a problem with some structured products — a conundrum that is more likely to benefit the issuer than the investor.

“That’s why most product providers are trying to push them out there, because they’re extremely high margins for the providers that offer them,” Murphy said.

“And if you’re paying away more fees as an investor, you’ve got less chance of meeting your investment objectives over the long-term,” Murphy said.

Advisers must assess the expected final outcome of each product to try and ascertain the fee level, as different products with different fees will create different outcomes.

By doing so, advisers will then be able to see the effect of whether the product design works and the embedded fees associated with it, Watkins said.

Price on the upside

Many Australian structured products offer a capital guarantee element, providing a floor on any losses when sharemarkets fall. But there can be a corresponding price to be paid on the upside, Murphy warns.

Take, for example, a protected structured product with exposure to the ASX 200.

“If you actually dig into the detail you might find you’re not getting full exposure to that market or [underlying investment],” Murphy said.

“It might be 75 per cent or 50 per cent of the upside — it’s never usually the full quota, or if it is, the premium that you’re paying away in terms of protection is so exorbitant that it will offset that.”

Some structured products use Constant Proportion Portfolio Insurance (CPPI) as a means of capital protection. Select Asset Management chief investment officer Dominic McCormick argues that while this “sell low, buy high” approach can appear cheap on the surface, it can be an inefficient method.

“Periods of poor performance, when the CPPI approach will reduce your exposure, is often the prelude to better performance, which investors may not fully participate in,” McCormick said.

Wanting it all

In Australia there have been no major “meltdowns or surprises” in the structured products market (apart, of course, from the UBS product in which the guarantee collapsed). Aside from that instance, structured products have largely done what they promised they would do, Watkins said.

But that doesn’t mean their investors are happy.

To protect capital, some products switch from equity to interest bearing products when sharemarkets fall. Capital protected products in particular have served a purpose in recent years, with investors acknowledging that, had they been in direct equities, they would have lost more of their capital. But while the downside protection was appreciated, missing out on the upside is not as welcome.

“A lot of people don’t like the fact that in the CPPI style products, they’re now locked into fixed interest,” Watkins said.

“So the product did exactly what it should have, but it’s still a product they don’t like.”

Capital protection - meeting an emotional need?

Murphy believes some who are gravitating towards more costly capital protected structured products are “being driven by their emotional experience in the recent past”. For both advisers and investors, a promise of capital protection may be welcome following the stomach-churning falls of the past year. This makes capital protected structured products “an easy pitch to a client”, according to Murphy.

“The flipside is that after the market has fallen so precipitously, is now the time to be worrying about your downside? I’d argue that from a longer term perspective, the risk is now more to your upside then your downside.”

McCormick also acknowledges that some may be comforted by the feeling of protection that these products can offer.

“But the financial planning industry should not be about giving clients placebos. It should be about giving clients what they need and educating them about what that should be,” McCormick said.

The feeling of security in structured products may also be somewhat misguided, supported by clever marketing. Some structured products marketing suggests “you can still get all the return but none of the risk, implying the traditional relationship between risk and return doesn’t exist for these products”, Murphy said.

“We don’t buy into that argument at all.

“People who can’t stomach the downside should be invested in a conservative portfolio of safe fixed interest assets that will generate an ongoing income that has low or no exposure to capital movement.”

Performance

With their sometimes complicated structures, structured products may look as if they can offer returns and outcomes that vanilla products cannot. But this doesn’t mean they shouldn’t be compared to simple investments during the analysis stage. Morningstar’s Murphy acknowledges that most structured products would have outperformed the equity markets over the past three years.

“But would they have outperformed just putting your money in the bank?”

Comparing the performance of the structured product to the performance of the underlying investment may also be misguided.

“I don’t look at a structured product and compare it to what the ASX200 is doing because with all the structuring around it, that’s not what the exposure or the risk return trade-off is comparable to,” Murphy said.

Over longer term periods, Murphy believes the benefits of structured products are unlikely to stack up. He advises planners to consider the performance of the average balanced fund over a rolling five-year basis.

“If you go back through time, you’ll find there are very few rolling five-year periods where a return on that sort of fund has been negative,” Murphy said.

“That’s not to say [a balanced fund] would never have a negative return, but on a three to five-year basis, a typical fund still offered you a positive return.”

This calls into question the need for capital protection, particularly when structured products require three and five-year lock-up periods.

Select’s McCormick has long questioned the value of structured products.

He argues that “proper diversification largely eliminates the need for such structured products from an investment perspective, particularly over the five to 12-year term typical of many structured products”.

“If the underlying investment engines of these structured products make sense then they should be included in portfolios directly, not after their potential benefits to portfolios have been heavily diluted or eliminated by the excessive costs and added inflexibility that structured products can bring.”

To McCormick, it is clear that “quality financial planners don’t need these structured products to put together sensible, well-diversified portfolios that preserve capital over the medium to long-term for their clients”.