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Structured Products and their Critics: Dispelling the Myths

By Eve Berlinska, StructuredProductReview.com

Structured products’ compelling performance results, defined risk/reward outcomes and adequate market/credit diversification potential in both the UK and the US market show it is way past time to let go of past prejudices. Whilst I cannot comment on some of the US market aspects as I do not have enough experience or insight in this area, some of the universal statements that appeared in the Forbes article, ‘Why you should avoid ‘Zombies’ structured notes?’, are biased and quite frankly untrue. Therefore, I felt compelled to respond to the central arguments raised.

In October 2014, Forbes published yet another article by serial structured product basher John Wasik warning readers about these investments. The author tries to convince readers that structured products have only disadvantages and risks. Benefits seem deliberately and erroneously omitted.

The article is crammed full of stereotypes. According to the author who continues a smear campaign against these investments, structured products are ‘dangerous’ they are backed by the credit of the bank, rather than being government insured, and ‘can certainly lose money’. These points are nonsensical - every investment involves risk, there is no doubt about it and very few investments have defined outcomes and capital protection which structured products have.

Complexity

Wasik criticises structured notes for being too complex. Complexity claims are often an argument put forward by those who do not want to understand or wish to undermine the value of these products. Having worked with both structured notes in the States and their counterparts on the other side of the pond in the UK, I have to disagree with the statement that structured investments are complex. Looking at it from an expert perspective with an overview of the market, the variety of outcomes and the benefit potential, such as defensive products offering gains when the markets are bearish are clear advantages. Furthermore, investors can understand outcomes and the circumstances that are needed to create them. Holding structured products as complementary investments within an investment portfolio can be a great tool to boost potential returns and diversify risks. While not all structured products are great, a careful selection process can identify good opportunities.

Wasik also suggests in the article: “While some deals work the way they are designed, other structured notes have caused thousands of investors harm…” – again an incorrect statement as we know exactly how structured products will perform under specific circumstances. The risks are precisely defined at outset too. Understanding how different product types work may require analysis of the options, but it is the manufacturers job, not the investor’s. Investors can explain how much risk they are willing to accept, but it is obvious that the more risk involved, the higher the potential returns – there is no such thing as a free lunch.

Credit risk

It is true that structured investments are backed by financial counterparties and thus credit risk needs to be considered. However, after the financial crisis, with banks being more heavily regulated with strict capital adequacy requirements and with a range of different counterparties to choose from, credit risk can be easily diversified. In the UK, less than 1% of structured products were linked to Lehman’s prior to their default – the other 99%+ performed exactly as defined.

The mainstream products that are part of the retail structured product space do not take much intelligence to comprehend. They can be defined as contracts between an investor who is willing to lock up his capital for a certain amount of time, and a provider. Terms of each investment are specified in the product literature and as long as the counterparty is able to meet its obligation at maturity, the contract will be fulfilled with no exceptions.

UK market

In the UK, a Financial Conduct Authority investigation discovered examples where IFAs still lack sufficient understanding of structured products and thus are reluctant to recommend them. While no one should recommend an investment without understanding it, if an Independent Financial Adviser does not take into account the full range of available investments, the UK regulator dictates that they can no longer call themselves ‘Independent’. To suggest that structured investments are ‘Zombies’ in the Forbes article shows a high level of misguided generalization and a lack of understanding.

The accusation that they reap huge commissions for the brokers selling them certainly does not apply to the UK market, as there is no commission and structured investments are sold on fee basis.

Conclusion

Whilst the direct impact of the collapse of Lehman Brothers on the vast majority of UK structured product investors was nil, the landscape subsequently changed dramatically. The structured product market participants improved their literature and went the extra mile to try to educate interested individuals. Educational materials, conferences and seminars are widely accessible and available for free to both advisers and investors. Whilst I can’t speak for the whole global market it is worth highlighting that in the UK at least, thanks to the high regulatory standards there is no place for hidden nuances or non-transparent features in structured products. They do what they say on the tin and understanding them should not be beyond any adviser’s capability.