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The Jury is Out on Whether Structured Products are Good Value

Emma Rees, Features Editor, 16 June 2008

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Whereas structured products were once used at the periphery of high net worth clients' portfolios, they have increasingly become central, particularly in times of heightened volatility. Wealth managers, however, are divided as to whether the benefits outweigh the costs.

Whereas structured products were once used at the periphery of high net worth clients' portfolios, they have increasingly become central, particularly in times of heightened volatility. Wealth managers, however, are divided as to whether the benefits outweigh the costs.

Their proponents say structured products have acquired an increasing breadth and flexibility in the last decade and can now be used on an entirely bespoke basis to achieve specific objectives in clients' portfolios. Fixed maturity dates allow the management of risk over a known time period, which is particularly useful in providing exposure to volatile assets.

The credit crunch boosted demand for structured products. According to industry data provider mtn-i, high net worth, private bank and family offices have been an important investor base for structured notes, with retail and institutional investors purchasing more than 19,600 structured notes worth more than $304 billion from 1 August, 2007, to the beginning of June 2008.

However, not everyone is convinced of the benefits. Critics argue that there are issues such as lack of pricing transparency and the fact that, over the long run, the cost of protection and reducing volatility comes at too high a price in foregone returns.

The firms most favourably disposed towards structured products tend to be those that have the muscle to negotiate the best terms with issuers, or indeed those that have investment banking arms that structure the products themselves. Boutique wealth firms and financial advisors are more likely to avoid them, in favour of diversified portfolios which are actively managed to protect capital when markets fall.

In their Global Investment Returns Yearbook 2006, ABN Amro and the London Business School analysed whether it made sense to protect a portfolio against downside risk and found that returns are eroded by more than risk is reduced.

Whereas between 1900 and 2006, US equities provided an annualised return of 9.8 per cent with volatility of 19.8 per cent (standard deviation), a protected portfolio which ensured each year's returns were no worse than -10 per cent would have given an annualised return of 6.9 per cent and a volatility of 18.6 per cent. A similar analysis of UK equities between 1930 and 2006 found that an annualised return of 11.5 per cent and volatility of 24.5 per cent fell to 9.5 per cent return and 19.2 per cent volatility with the same level of protection.

According to David Kidd, chief investment officer, Arbuthnot Latham, structured products primarily have a role to play when clients feel uncomfortable even if the value of their portfolio fluctuates just four or five per cent in the short term.

He said the cost of structured products has dropped due to healthy competition in this space, and that now is not the ideal time to buy as market volatility means that the option premium is highly priced:

"We prefer to have well-diversified portfolios and implement strong views where we are confident on a sector or region. Looking at Japan for example, out of three funds linked to the region, only one is a structured product," he said.

The Swiss private bank Pictet is a sceptic. It has told WealthBriefing that it does not offer structured products to clients.

Thomas Becket, director investment strategy, Psigma, said the drawback with structured products is their illiquidity in secondary markets and their potential to be overcomplicated and expensive. Also, their issuance by big banks means that at the moment there is a credit risk attached to them, he said.

"The theme of investment markets at the moment is dislocation, dislocation, dislocation and there are so many other things to focus on. The markets are finely balanced and there is a world of opportunity out there," he said.

Advocates of structured products argue they are efficient in managing risk, offering tailored solutions for a targeted risk profile. Whereas those structured notes sold through the IFA sector tend to have a longer tie-in period of 3-5 years, discretionary wealth managers can often bulk-buy structured notes tailored specifically for their clients rather than having to buy them off the shelf.

The research for the Global Investment Returns Yearbook concluded that protected portfolios had long term risk-reward ratios that were inferior to splitting the investment between an equity index fund and Treasury bills. However, as their underlying assets are becoming more varied, structured products are increasingly being used by wealth managers both to diversify into more obscure asset classes, as well as providing a means of hedging risks in currencies, inflation and interest rates.

Philip Watson, head of investment analysis, Citi Private Bank, said that there are "interesting opportunities that stem from turning clients' fears into investments where clients can actually monetise their own concerns". 

One example is a structured note linked to the dollar's exchange rate against sterling, giving investors a geared exposure of 180 per cent of any decline in sterling against the greenback.

"This might be a worthwhile investment for a client concerned about the depreciation of their assets denominated in sterling," said Mr Watson.

Inflation linked structured products are also proving popular. mtn-i reports that the number has doubled from the same period a year ago. Citi has been looking at this area for those clients concerned as to how inflation may impact the value of their portfolios. It is using commodities-linked products, including a principal-protected capital markets idea linked to a two year-meat and feedstock basket, as well as a "sideways notes" where which clients can participate in equity markets and achieve positive returns whether the market goes up or down. Beyond a certain threshold, however, say a 45 per cent rise or fall in the value of the market, the investment pays a return linked to inflation, which means that the investor gets their money back, plus increases in inflation.

Rupert Silver, a director at Credo, a UK-based wealth manager, said volatility has had a significant effect on the pricing of structured products. Prices have fallen in the last three to four weeks as volatility has died down significantly; the options price is better for investors and more can be put into the zero coupon bond:

"Five year swap rates have moved from 5.2 per cent to 5.9 per cent in the last two or three days. Over the last three or four weeks, structured products have become more appealing and we have gone long volatility for the first time," he said.

Credo uses structured products, particularly where there is an opportunity to play an asset which has considerable risks attached.

"The most attractive areas to play are those like commodities where prices have already risen so far and which are likely to continue rising, but where there is a possibility a bubble has formed. I see less value in a product which goes long the FTSE," he said.

Courtiers, a UK investment firm, is using "autocalls" on major indices on which it has done a huge amount of modeling. "We believe that the pay-off profiles are under pricing by 5 or 6 per cent," says Gary Reynolds, chief investment officer at Courtiers. "The probability of the barriers set being breached is so remote as to be negligible, so investors are being more than compensated for the risks they are taking."

However, whilst he advocates the use of structured products as part of a comprehensive portfolio strategy, Mr Reynolds sounded a note of caution for those investors going it alone as while these products can seem low risk in providing a capital guarantee, this can mean a zero return at the end of six years.

"The amount of modelling we do on comparative distributions and likelihood of outperformance is immense and the average investor just doesn't do that," he said.

Citi Private Bank's Mr Watson said it is only possible to answer the question of how expensive the cost of protection or participation is on a case by case basis. In recent times, however, he says investors have come to fully appreciate how cruel the market can be:

"With structured products, you are in certain instances removing a capital erosion risk over a defined time horizon and for many clients, that is a level of comfort they are very willing and happy to pay for."

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