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Three advantages of structured products over passives and three disadvantages

By Chris Taylor, Managing Director of The Investment Bridge

Many UK advisers and planners have increasingly embraced passive and smart beta investment strategies within portfolios, over the last decade, some to the point of now using passive options exclusively. The arguments in the active/passive debate are well known and aired, but what has been less well considered are the benefits and advantages that structured investments offer as passive solutions, over and above, or at least in conjunction with, pure passive propositions.

The simple fact is that there are some things that passive and smart beta funds don’t do, and can’t do, and will never be able to do, that structured investments can do. And there are some things that passive and smart beta funds can do that structured investments can do more efficiently and effectively.

Constraining the points to highlighting just three main and generic advantages, structured investments offer:

1. The ability to change exposure to market risk, in particular market downside. Nobody takes market risk for the sake of it and everybody would avoid it if it was possible – and it is through structured investments, which can either completely remove any and all market risk, or at least reduce it, or at the very least precisely define any exposure that will exist.

In the first instance, of removing market downside completely, structured investments can be produced with full and absolute protection of capital from market risk – albeit with exposure to counterparty credit risk. It is also possible for structured deposits to be used, which include compensation scheme protection against the credit risk, and thus give market exposure with exactly the same risk to capital as cash.

In the second instance, of reducing exposure to market risk, many structured investments utilise ‘barriers’ that provide full protection of capital unless the underlying asset is lower than a pre-defined level, often only measured at the end of the investment term. This approach significantly alters client’s exposure to market risk – with history showing that many deep barrier levels on many indices have never been breached, by even the most extreme market events and conditions.

2. The ability to optimise returns, including obtaining pre-defined returns, that will be delivered under contractual obligation, based on known conditions/parameters. This can include amplifying and multiplying market upside, for example through a higher than 1-for-1 participation rate in the rise of the underlying index – in fact, multiplication of the index’s return can be as high as 10x, albeit such high multipliers may come with an overall cap on the total return possible (but not always). In addition, structured investments can also create and deliver returns from markets that do not have to rise, and in fact even in markets that fall.

With markets showing significant propensity for extended and recurring periods of flat and range bound returns including investment strategies that can optimise returns and contractually ensure positive returns, even with the accompanying credit risk, can only be seen as bringing something extra and advantageous to investor portfolios.

3. And lastly, as already alluded to, everything that structured investments do is done by contract – legal obligations upon the issuer/counterparty to deliver precisely what is stated, as opposed to just an investment aim or hope.

It is not possible for a structured investment issuer to wriggle away from delivering anything other than precisely what was stated at the outset – there is simply no wriggle room.

There will be no underperformance, no tracking error, not even in respect of charges, no matter how small these can be for most passive strategies.

The disadvantages of structured investments are, somewhat perversely, better known to advisers and planners in the UK than the benefits – highlighting the challenge that the structured investments industry has faced over the years in engaging with a wider audience.

But this asymmetrical knowledge amongst some advisers and planners needs to be challenged and changed.

The structured investment industry is open about the risks and limitations of its propositions, and these are positioned appropriately alongside the benefits.

Highlighting three generic disadvantages of structured investments, in the context of comparison with passive funds, these include:

1. Structured investments are often based upon underlying index links, but the indices are usually not total return indices, i.e. dividends are not taken into account.

Nobody is disputing the importance of dividends, and analysis of any structured products’ specific risk and return features is needed to evaluate whether any removal or reduction of market risk, together with the level of potentially optimised and possibly pre-determined returns, is sensible.

The potential for strong returns from even flat or falling markets, with deep protection against market risk, or for returns that can be multiplied, possibly ten-fold, may indeed be viewed as more than adequate recompense for dividends.

And, of course it should be borne in mind that dividends are not part of or such an important component of all markets and assets, as they are for UK equities.

2. Credit risk. The overt fact is that most structured investments introduce credit exposure for the investor.

But it should be understood that credit risk is not necessarily a bad thing in itself, and many investors’ portfolios would benefit from less market risk and more credit risk.

However, it is certainly true that credit risk must be assessed and understood by investors, as counterparty default could mean a significant loss of capital.

In reality, the risk of major global banks defaulting can fairly be deemed to be minimal – or the very fabric of global economies would be in major trouble. And, indeed, it is possible for credit risk to be mitigated or even removed, for instance through collateralization, for advisers/planners that may accept and wish to embrace the benefits of structured investments, but who remain concerned about counterparty risk.

3. Liquidity, which may be reduced through structured investments.

A common and reverberating misconception about structured investments is that they do not provide liquidity and they lock investors in for the full duration of the investment term. But the simple fact is that this is usually not the case.

It is possible that intra term liquidity might only be weekly or monthly and, on the surface, clearly this reduces liquidity – albeit that daily liquidity can usually be arranged. However, as per the approach of the leading US endowments, that many passive funds adviser/planner proponents in the UK ascribe to, it can be sensible to segregate portfolios with certain elements having the maximum liquidity, for contingency needs, and other elements having less or even no liquidity, where it is realistically not expected to be needed and the costs of superfluous liquidity can be reduced or avoided.

It should also be highlighted that intra term liquidity within most structured products is successfully, regularly and actively used by the advisers and money managers who embrace structured investments.

The views expressed in this article are those of the author and do not necessarily represent those of StructuredProductReview.com.