Structured products: Where to now?

Structured products have received more than their fair share of criticism over the past year as advisers, investors, commentators and regulators have sought to sheet home blame for the carnage in investment portfolios. This is despite structured products comprising less than two per cent of retail funds.

Common themes in this criticism have been lack of transparency, lack of liquidity, complexity and high fees. Some of this is clearly justified, however much of the problem arises from the way these products were sold by advisers and manufacturers and, importantly, the messages that were delivered to (or received by) clients.

Education, understanding and quality disclosure are critical to the client experience. Sadly, in many cases this was lacking as dealer groups and advisers drove manufacturers to deliver higher and higher fees. This is not a call for greater ‘box ticking’ disclosure to be included in ever-growing disclosure documents; rather it is a call for concise, plain English explanations from advisers who fully understand what they are selling and why the product deserves a place in the client’s portfolio.

Former Chief Justice Sir Anthony Mason expressed this well when he said, “Detailed and dense disclosure is the most effective means of concealment”.

Unfortunately our regulator hasn’t been listening. Investors and advisers, too, haven’t been listening. Both got caught up in the heady days of ever-rising stock prices and relatively low interest rates, and ignored the importance of only investing in things they understood. Many found it tiresome or too difficult to read the disclosure that was provided and adopted the approach of Pierpont who — when writing in The Australian Financial Review, less eloquently than Sir Anthony but perhaps more wittily, echoing his sentiments — said that “the prospectus is the fat thing in front of the application form”.

Traditionally, 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 deliver a synthetic exposure to an asset or basket of assets, which is often internally geared and, in most cases, offers some level of capital protection.

The market for these products grew rapidly through the period from 2005 to 2007, before declining in 2008 as the early fallout from the credit crises hit with the demise of Basis Capital and Absolute Capital, and restrictions in credit began to bite.

Little was done in the 2009/10 tax year, as falling interest rates meant the cost of capital protection (which is largely dependent on the cost of a zero coupon bond of the appropriate term) became prohibitive and very high volatility meant that the options generally used to gain exposure to the underlying investment became too expensive to deliver a meaningful exposure. The few products launched required much greater complexity to deliver a meaningful outcome, and were not particularly well received by gun-shy investors and, in my view, delivered a very poor investment outlook.

Looking forward, however, the picture looks somewhat rosier. Markets have started to recover, with the Australian stock market having its best quarter for 20 years, volatility has reduced significantly, interest rates are showing signs of moving up and some activity is returning to the credit markets.

Some concerns remain that we may have a ‘double dip’ or ‘W’-shaped recovery, which would support a desire for some form of downside protection when investors move aggressively back into the stock market.

On the tax front, too, things have improved. The Australian Taxation Office (ATO) has provided certainty around the tax treatment of Deferred Purchase Agreements, or DPAs — the most common form of structure used for these products. This means that the gain on these investments will be treated as capital gains rather than ordinary income and so will attract the CGT discount when realised on maturity of the investment.

Other traditional tax planning products, such as trees and horticultural investments, are no longer quite as attractive and investors are in shock after the collapse of the two biggest players in this area.

Accordingly, opportunities for tax planning are now focused on superannuation and negative gearing. Many investors seek some form of downside protection when investing in shares with borrowed money.

All of this points to a recovery in the market for structured products. However, investors and advisers will be more discerning. The successful players will be those who can deliver the outcomes expected, with simple products explained clearly. Investors will pay a premium for simple clear disclosure. Other concerns for investors are liquidity and clarity around redemption pricing.

The cloud behind this silver lining is what the regulator will do. There is a growing international push for greater regulation and perhaps restricting retail access to some of these products. Were this increased regulation to result in larger, more generic, disclosure documents, investors will be the losers.

On the positive side, our regulator seems to be resisting this global push and former Minister for Superannuation and Corporate Law, Senator Nick Sherry, has made a number of public statements about simplifying disclosure documents. It remains to be seen what happens over the next year or so.

Vince Scully is chief executive of boutique financial services provider Calliva. A chartered accountant by training, he spent eight years at Macquarie Bank in project and structured finance before cofounding Calliva in 2004.