Structured Products
Author:
Kieran Conlon
It sounds too good to be true, doesn’t it? In fact, after the past 18 months of falling property and equity values, you would be justifiably suspicious of anybody making any promises to you, let alone promises of one-way investment bets. Well, your scepticism is well placed but there are several very interesting ways in which investors can expose themselves to favourable movements in asset prices while, at the same time, limiting or eliminating exposure to adverse movements. In this article Kieran Conlon takes a highlevel look at the first of these – structured products – and considers whether, in reality, they might represent a one-way bet.
A Structured Approach
Structured products have been widely used by European and US investors for many years. However, they are becoming increasingly familiar to Irish investors, particularly those wishing to manage, or in some cases capitalise on, downside investment risk. In fact, in one form or another, Irish institutions have issued about €10 billion of structured products in the past five years.
Structured products are financial instruments from which investors typically derive a return based on the combined performance of a bond or deposit and a derivative. Usually, but not always, lasting for a fixed term, they range in complexity from relatively straightforward to highly complicated. Some of the most straightforward structured products, for example tracker bonds, have been familiar to investors for many years. In more recent years the range of underlying exposures and the complexity of the structures has greatly increased.
Structured products are no different from any investment – the potential return needs to be evaluated in the context of the level of risk being taken. Many structured products are designed to provide income in the form of an enhanced yield compared to what might be available on a straightforward bond or deposit investment. Therefore, while some structured products might have the potential to deliver very high returns, many should be evaluated in the first instance by reference to the excess return they expect to generate over asimilarly risk-rated bond or deposit.
A key attraction of structured products in the current climate is the partial or total capital guarantee that many of them provide. However, there are some important considerations (See Table 1) to be borne in mind in relation to capital guarantees.
The majority of an investor’s capital in a structured product is normally used to fund the bond or deposit that provides the capital guarantee. The balance, after deduction of charges, is used to purchase an option or an equity swap that provides the investor with exposure to one or a basket of ‘underlying’ securities. Common underlyings include stock indices, individual shares and commodities.
In some cases the investor gains if the value of the underlying increases; in other cases it works the opposite way, and occasionally it can work both ways. It is important to study the fine detail of the term sheets governing structured products, and well worth obtaining some professional advice, as there is always a risk/reward tradeoff.
In order to obtain the benefit of what may seem on initial reading to be a one-way bet, investors usually sacrifice some of their potential gain or risk tying their capital up for an extended period with limited prospect of significant gain.
Honours Maths
Complex option pricing models are used to determine the cost of the options, often issued by large investment banks, used in structured products. Even sophisticated investors sometimes struggle to obtain transparency as to how much of the total option price represents fees or profit for the issuer. In general terms, pricing is substantially influenced by both interest rates and the volatility of the underlying investment. If both interest rate and volatilitycharacteristics are supportive then structured products can be an excellent and affordable way for investors to obtain exposure in a lowrisk manner to various asset price movements.
However, in addition to ‘plain vanilla’ options, there are many variations that can be introduced to structured products that will influence their cost, and understanding the calculations might challenge even honours mathematicians! Some of the more common variations and variables include averaging, auto-calls, caps and participation levels. These, along with some of the more common terminology encountered in structured products, are explained in Table 2 (Table omitted on web edition).
A Worthwhile Option?
Investors sometimes get seduced by the prospect of high participation levels and racy potential returns on structured products. However, when evaluating any structured product, the most important factor to consider in the first instance is the investment thesis driving the underlying. For example, a 100% capital guaranteed opportunity to participate in 50% of the performance of a specified index might be a worthwhile investment. However, the same opportunity but with a 200% participation level and a soft protection barrier of 75% might be a much less advisable investment for many investors. Despite the potential for significantly higher upside, if the underlying index tends to be volatile and markets are bearish, then there is a significant chance of the investor losing a material part of their original investment.
The use of structured products to ‘bet’ on a recovery in the price of banking shares has been popular in many countries in 2008. However, in many cases the full extent of investors’ research of the underlying investment thesis was ‘they’ve fallen so far, they can’t go much further’. Some of those who invested on that basis in the first quarter of 2008 with soft capital protection have learned an expensive lesson. Not alone have they breached protection barriers and become exposed to significant losses but investors’ capital is also tied up, in some cases for several more years. So, even though structured products can be a very sensible way to gain protected exposure to a wide range of asset price movements, they are not necessarily a one-way bet. The usual caveats of doing proper research and getting good advice always apply!
Kieran Conlon, B Comm, M Acc, FCA, QFA is a director of Aria Wealth & Investment (www.ariawealth.ie).