Before you start, this one might not be for the fainthearted. I’m writing this in response to an article I read entirely dismissing structured products. In my response I’ve tried my best to simplify as much as possible what are, by their very nature, complex products in the hope of persuading you that there are 2 sides to this conversation. While a lot of these products should not be touched by individual investors, sometimes and in some circumstances they could be of use for the individual, so long as they properly understand what it is they are buying. As a result I hope to make the point that making a blanket stay away message on any financial product should at least show the whole picture to let investors make their own minds up. Now with any luck I haven’t scared you off too much before you start! On the contrary, I hope I’ve encouraged you to expand your knowledge, so please read on!
Earlier this week I stumbled upon an
article written for MoneyWeek telling people to steer completely clear of
structured products (“Don’t fall for structured products”). That no one should invest in them
ever because they are all rubbish and the investor would always lose out. The
author based her complete dismissal of all of these products on a couple of new
products she’d been sent which she deemed to be too risky to even think about, because
mostly there was too much downside potential for the investor with a very limited
upside. Whilst I believe she had a point in reference to the two products she
mentioned, it struck me very much as being a severe case of using two bad
examples for the purpose of dismissing everything in that field. It’s a bit
like telling me I should keep my money under a mattress because the 2 savings
accounts I looked at give 0% interest and are both at nearly bankrupt banks, so
as a result there’s no point saving in any savings accounts (although some
might argue at the moment it’s just as effective!). In reality what you’d do
would be to look out for the best account for you which offers the best return.
All financial products are essentially the same from that respect.
Now
I’m aware that a large number of the people reading the blog will be wondering
what on earth I’m talking about when I speak of structured products. Sure, I
well know my family and most of my friends used to look at me confused when I
mentioned I worked with structured derivatives. They still came out wondering
what it was I did when I tried to explain. But, for the hope of not boring
those already in the industry, I think it’s worthwhile to give those not in the
know a brief overview.
In
relatively simple terms, a structured product uses derivatives on a mixture of
different assets to create a tailored payoff for the investor. This mix of
assets could include anything (bonds, equity indices, individual stocks, fx
etc.). Most of you will probably have heard of some of the more infamous
structured products which assisted in bringing about the financial crises –
Mortgage Backed Securities (MBS), Collateral Debt Obligations (CDOs) for
example - and in it you can already see some of the dangers of certain of these
products. The specific types of structured product discussed in the money week
article however are what are known as equity structured notes.
Equity
structured notes themselves can take many forms, but it effectively will give
you a payoff linked to the performance of a single equity or index or a group
of equities/indices over a period of time. The main benefit of these products
is that they will sometimes offer to protect your capital somewhat (in a
process known as capital protection) through selling you a bond as part of the
structure. (It’s important to know at
this point, that this capital protection is provided by the institution that is
issuing the product, so there is a risk there.) These products can range
massively in complexity from the simple ones, offering you only the upside on
the performance of an index, or they can be extremely complex, involving all
sorts of caveats as to what your return will be based on. There are whole books
written and still to be written on these, but hopefully you have the very basic
gist. As you can see, even from the off they’re not for everyone!
The
moneyweek article focused on 2 particular products both of whose payoff was on
the slightly more complex side for a basic investor. In them, the investor only
got a small coupon each quarter from their investment and even this was
dependent on all 3 stocks used in the product performing positively over the 2
year timeframe. If all 3 shares fell by more than 20% in that time, then you
stood at risk of losing some if not all of the capital you put in (although to
lose all your capital HSBC, BP and Vodafone’s share price would all have to
fall to 0, an apocalyptic thought for any pension fund holder!). As you can see,
a product of this kind has inherent risks and this is one where the upside
certainly doesn’t seem to necessarily compensate for the downside. So if you
were now interested in either of these products as a private investor I’d
suggest you read what I wrote a few weeks ago on the difference between speculation and gambling so you can decide which it is you are doing and whether blackjack is more
suitable.
But they’re
not all this complex. What if you could buy a structured note which pretty much
guaranteed your capital 100% and also gave you a 55% coupon after 5 years? All
that you’d need would be for the FTSE 100 to be above what it was now in 5
years time, just by 1 point. If it is you get your money back as well as 55%,
if it isn’t then you get the capital you invested back. Or alternatively what
if you similarly were offered a coupon of 4 times the performance of the
S&P 500 over the next 5 years up to a maximum of 80% with your capital
similarly protected should the S&P 500 finish below the current rate?
There’s certainly reasons not to take these products. After all, the FTSE 100
may perform better than 55% in that time frame and you’ve then lost out so in
theory you would have been better off buying directly into a FTSE 100 tracker
and holding it for the 5 years. If the S&P 500 finishes below today’s level
then you only get your money back with no return effectively eroding the value
of the money you had when you could have just put it in a savings account and
at least earned some interest. But therein as always lies the benefit of
hindsight. As an investor, we could always have made more money if we had a
time machine.
If I
had offered you these products 4 years ago in 2008, with all the uncertainty
that was around then, there’s a fair chance that some of you would have found
these quite appealing. Barclays offered these exact products back then and they
wouldn’t have been the only ones. Markets were trading near lows not seen since
2003 with the FTSE around the 3600 mark and S&P around 700. There was
uncertainty as to how much they were likely to rise in the next few years and
meanwhile with interest rates approaching or already at their all-time lows there
was not much to be returned by keeping your money in a savings account. Given
all that uncertainty, some investors may have assessed that markets were going
to go up, but it was difficult to see how much, and there was the possibility
that in 5 years time they could be near to where they currently were. You’re
afraid of losing your capital if you invest directly in the market, so the
capital protection element gives you comfort around that, (assuming you have faith
the institution issuing will still be around then). In addition the prospect of
a 55% return should the FTSE have been even 1% above its level at the time is a
better prospect than only 1% by just sticking your money in a FTSE tracker. So for
an investor who had a mildly positive view on the FTSE 100 over that 5 year
period, but wasn’t so convinced on the size of the upside and also wanted to
protect his investment, this may have suited him. It offered some kind of
security and the potential for a decent return of 55% so long as the FTSE was
in even a small element of positivity after the 5 years. There are plenty of
this type of product available today from various institutions.
But of course there are risks, after all there’s no such thing as a free lunch!
- Loss of upside: On the simplest level you may feel you’ve protected yourself against any falls, but you’ve also limited yourself on the upside. However as a cost of giving yourself protection, you have to accept that you won’t be able to take advantage should markets really take off. It’s the choice you make. In the end, you want to make sure you get the return you are aiming for. So long as you’ve done that then there should be no regrets.
- The Capital Protection Risk (Counterparty Risk): As I alluded to before, the capital protection is only as good as the company which issues the note. There’s no sure thing in this world, and you need to know who is telling you they’re protecting your money because if they go under then your money goes under. It is estimated that investors held in the region of $18bn worth of Lehman Brothers issued structured products when they declared bankruptcy! Those investors now need to queue up with all the other creditors to see what they’ll get back. It’s important to assess who is guaranteeing your capital but, as Lehman proved, nothing is assured.
- Liquidity Risk (The ability to sell): In theory the structured products that individual investors can buy are tradeable on the market, so the investor can sell the product as and when they want. In reality however there are only a limited number of each note issued each time, and the ability to sell is, as with any security, based on the willingness of someone to buy. As a result whilst there is a market on offer, if things don’t turn out as you’d hoped and you want to get out before the note reaches the end of its life, you may not get back as much as you’d hoped.
- Complexity: As I mentioned much earlier, structured notes can be very complex. Even notes which appear to offer a very simple payoff at the end may contain several features whereby your capital may be affected should the index or underlying share hit certain levels. Like an antibiotic, always read the label. You want to make sure you’ve read the entire termsheet and all the caveats so you know what will happen to your money! Don’t just be taken by the high potential return offered if you can’t figure out how you get there. Even if you can understand it, it doesn’t necessarily make it a good investment compared to a simpler solution.
As
you can see from all of this, these products are certainly not for everyone and
in some cases it’s debateable whether the risks make them suitable for any
individual investor. They can b complex, but it doesn’t mean you shouldn’t try
to educate yourself to understand them. There are times and in certain
situations where there is the potential for an individual investor to make a
true risk assessment on an equity structured note and deem it to be a better
fit to his/her risk profile at that moment in time than a straight investment
into an equity or equity index. That is the decision for the individual
investor to make. I’m not a financial advisor, nor do I claim to be offering
financial advice. I’ve previously spent 8 years working with structured equity
traders so I probably have more knowledge on this than most of the general
public but I stand to make no money by explaining them. Are they suitable for
everyone? Certainly not. Are they suitable for most people? No way. But that
doesn’t mean you should just reject them out of hand. Everyone deserves to
understand a bit more of what they’re being told to steer clear from so they
can make their own decisions. Hopefully I’ve gone a little further in doing
that!
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