22 Sep 2020

Managing risk and returns through structured products

Brian McMillan

Investec Structured Products

Uncertainty around a second Covid wave abounds in global markets making it difficult for investment advisers to manage risk while seeking meaningful returns. Structured products are a potential solution.

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Central banks and governments have responded to the global pandemic with unprecedented levels of support for their economies, in the form of direct assistance and liquidity.  Thanks to these injections of liquidity and the decision by many governments to start opening up their economies, equity markets have rebounded from their March lows. 

 

Many of the world’s leading indices were even up for the year to date by the end of June.  However fears of further waves of infections and uncertainty about when or if a Covid-19 vaccine will be produced, imply a risky outlook for equities in the next 12 to 24 months.  While cash and bonds can provide protection against equity downside risk in the short to medium term, interest rates around the world remain at multi-year, or even all-time lows, leaving investors with little to no returns.  For investment advisers, this makes for a tricky task in finding ways of managing risk while seeking meaningful returns.

 

Structured products can, however, help advisers to manage this dilemma.  Thanks to features like capital protection and geared returns, structured products can be part of the solution. Indeed, structured products have not just provided an effective risk mitigation tool to protect against the inevitable downturns that do occur, they have also been effective for producing inflation-beating, hard currency returns. As such, they warrant consideration as part of a balanced investment portfolio. 

 

So what should advisers look out for when considering a structured product?

While each structured product is different, most share the following features, which could influence the decision: 

 

Capital protection: Capital protection is probably the best-known feature of structured products. A typical structured product (usually with a maturity of between three and five years), will have a 100% capital protection, or with protection of losses up to a certain percentage (say 20% or 30%). This feature is attractive for investors concerned about stock market volatility over the medium term.

Geared returns:  This simply means that investors earn a multiple of the return of the underlying index or group of indices. Returns are often capped at a certain level, but investors will still earn the multiple up to that level, at which point the investment return is capped. For example, the structure may give the investor two times the return of the underlying index, capped at 60%. So if the index grows by 50% over five years, the investor will earn a 100% return. If the index grows by more than the 60% cap, the investor will earn 120% (the 60% times two). Only if the index returns more than 120%, will the investor lose out on the upside beyond that level. These payoffs are therefore very useful for investors who are bearish or only mildly bullish about the underlying market.

Returns can be in rands or foreign currency: It’s important to look at the currency to which the product is linked. Structured products will often link returns to a well-known stock market index, such as the MSCI World, S&P 500 or FTSE 100. Others will be linked to a portfolio of various indices. Some may offer the return in US dollars, euros or sterling, while for others, the returns will be in rands. Investors will choose the investment product depending on which currency exposure they are looking for.

Brian McMillan
Brian McMillan, Investec Structured Products

Structured products have not just provided an effective risk mitigation tool to protect against the inevitable downturns that do occur, they have also been effective for producing inflation-beating, hard currency returns. As such, they warrant consideration as part of a balanced investment portfolio.

In addition, investors should consider a few important questions:

How does the structured product fit into his or her overall  portfolio strategy? In general, the best advice for investors is to hold a well-diversified portfolio of assets for the long term.  Structured products can be a useful tool for diversification, thanks to their capital protection and geared return features. The indices they reference are typically well-diversified as well. Investors need to look at how these features fit into their overall investment strategy.

And, leading from this:

Is the investment optimal from a tax and retirement planning point of view? The three to five-year term of a typical structured product addresses this, but increasingly investors want investments that are suitable for a retirement vehicle, such as a retirement annuity or living annuity. Investments can be structured to comply with the guidelines of regulation 28 of the Pension Funds Act.  Regulation 28 of the Pension Funds Act is designed to protect investors by setting guidelines for diversification across asset classes, including an offshore component.

What are the risks? Structured products are generally low-risk investments but are not risk-free. Investors should, for example, be cognisant of credit risk. A structured product is essentially a contract between the investor and issuer, with the latter promising to deliver the returns described in the contract. Most structures will be issued by well-known, highly-rated banks, so the risk is generally low, but not zero. 

Another issue to be aware of is liquidity. As noted above, most structured products are designed to be held for three to five years, so ideally investors should only invest money that they’re prepared to put away over that length of time. Circumstances can change, however, and investors may need access to their cash due to unforeseen events. Market makers may offer to help investors to find a willing buyer should the investor need access to capital.

In short, once one understands a few basic concepts, structured products need not be complex at all. Payoff profiles are simple and easy to understand, with no unexpected charges or costs (these are typically already factored into the pay-off). If held to maturity, they are a tax-efficient and easy way to get exposure to markets and currencies without assuming major risks. 

  • Disclaimer

    Investec Corporate and Institutional Banking (referred herein as “Investec”) is a division of Investec Bank Limited, registration number 1969/004763/06, an Authorised Financial Services Provider (11750) and a member of the JSE. The views expressed are those of the contributors at the time of publication and do not represent the views of Investec. These views do not constitute a recommendation or advice and should not be treated as such.