Most investors appreciate that investing in shares is the best way to generate long term returns. As an asset class, equities deliver the best inflation-beating performance over bonds and cash.
South Africans however face an enormous range of choices when it comes to deciding how to gain exposure to stock markets. If they invest in a unit trust, they would need to decide which managers to choose, which strategies best suit investment needs, and which currencies or regions they should invest in.
The decisions they make can have a meaningful impact on their investment outcomes. Performance between different fund managers and different regions of the world can vary significantly.
Equity fund investments are also heavily influenced by what the market does. In a crash like there was in 2008, all equity fund managers will be affected.
These are the uncertainties that investors in unit trusts have to accept. There is a very broad range of possible outcomes, and there is no way of knowing beforehand what that range might be.
These unknowns are what are influencing many South African investors to look at the alternative offered by structured products. These are vehicles that use financial instruments to create predetermined parameters for how an investment could behave over a certain period.
They do this by investing in a combination of a bond and options on the market performance. The invested capital is protected by the bond maturity value, while the options provide exposure to any potential upside.
“Rather than be purely at the whim of the market, this is something that we consider in our product design,” explains Japie Lubbe from Investec Bank. “The key question during this stage is to determine the balance between risk and reward. We consider prevailing market views, historical market performance and typical investor risk appetite to decide how much capital we want to protect, and on the other hand the amount of upside we want to target. ”
A different mindset
Investing in this kind of product requires a very different kind of thinking. Instead of hunting for value in a market or trying to analyse which manager is most likely to perform in the future, investors are presented with set possibilities, and only need to decide if these meet their desired outcomes.
An example is the Investec Offshore Protected Share, which is currently open for investment. It provides exposure to a selection of international indices, including 40% to the US S&P 500, 15% to the Nikkei 225 in Japan, 30% to the EuroStoxx 50 and 15% to the MSCI Emerging Markets.
The product offers investors a minimum return of 4% in US dollars if these markets are down or flat over a five year term. If however they are up, investors will enjoy double the growth up to a total maximum of 50%. This would represent an annualised return of 8.45%.
“With structured products, rather than running all the risk of not knowing the outcomes, you are investing in something that has been designed with all the probabilities taken into account,” says Lubbe. “You do however still take on risk, which is that the bond issuer defaults.”
The big advantage for investors is that this means you are able to determine beforehand whether the investment is likely to meet your objectives.
“The thing we often miss when we're investing is to understand what the problem is that we are solving for, and which strategy is the best one to help us address that,” says Ashburton's Andrew Wolfson. “Any investment strategy should be a way to help us achieve a desired goal or outcome.”
This means that structured products are not necessarily suitable for everyone. An investor needs to decide if the risk and return profile will help them achieve what they are looking for.
Lubbe also recommends that these products only make up 10% to 15% of an overall portfolio. This is to ensure that the investor is not over-exposed to counter-party credit risk.
Particularly in the current market conditions, however, where uncertainties are high, structured products can provide a degree of security within a portfolio.
“Investors are used to a world where they just have to take their chances, and whether the market goes up or down they just have to be happy,” says Lubbe. “But with structured products, the range of outcomes is limited. The investor can then decide if they are prepared to accept this range.”