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“Smart Beta”, “Passive Plus” – Structured Products are in Danger of Becoming Fashionable!

By Clive Moore, Managing Director at IDAD Ltd

Yes, it looks like it’s finally happening; whole new sectors of the market are becoming fans of structured products. Whisper it carefully though, structured products themselves still elicit unsavoury responses from some, but increasingly those advisers and investment managers who have come to the conclusion that passive investing can add something to their portfolios, in terms of efficiency and assistance in matching or beating benchmarks, seem to be realising that returns can be enhanced by using the same methods employed in structured products for over 20 years.

If you’re reading this article, you probably won’t need a hard sell on the benefits of SPs, but it’s often useful to look at things from a fresh perspective – sometimes it helps to reinforce the benefits of a solution you’ve regularly been choosing.

Asset Allocation

A lot of investment advisers aren’t specialists in every market around the World (actually, none are) but a lot of investment strategies call for investment in different asset classes and geographies as a quite sensible way of delivering the desired returns in the most efficient way for investors. Specialist funds can be expensive and often don’t match the passive options that may be available. While simple ETFs or ETNs can be a low cost and efficient way of matching market performance, they aren’t necessarily the most efficient way of matching the investment objectives.

If, for example, the investment advisor is hoping for returns of 10% p.a. from an emerging market index, why not buy an auto-call with a 10% p.a. coupon and a good level of capital protection on the downside? This will either deliver the hoped for return, or the capital protection is likely to cut in at maturity and deliver a better return than the underlying investment. Of course, if the investment strategy changes at any point, the SP can be sold just like any other asset and it’s likely the value would reflect at least some of the growth (if there had been any) or would deliver a higher return (because of the capital protection element) than a direct investment. If, however, the only objective is to share in all the growth of the underlying, see other options below…

Beta Beaters

A catchy name for a very simple strategy that isn’t used often enough. By using an option strategy that includes giving up the right to future dividends and capping the total return, it’s easy to achieve enhanced levels of return on an underlying asset. For example, on a five year investment, the return could be 130% of the level of the FTSE Index with a cap at 15% p.a. If, at maturity the Index was at 110% of its starting level, the return would be 143% (43% growth over 5 years). If the Index had fallen by 20% the return would be 104% (80 x 130%) – the cap would be hit if the Index had grown by around 38% or more (returning 180% to investors)

Not only can this deliver returns in a more tax-efficient manner than a standard growth + dividends investment, the actual returns should be higher in most expected scenarios. I’ll let you do the sums, but for example, if we assume net 2.5% p.a. for dividends (after tax and charges) the non-structured alternative underperforms unless there is a large fall or very high growth in the Index.

Synthetic Zero (a blast from the past)

I’m not sure anyone uses this term to describe a “digital” pay-off any more – it was popular as some parts of the market moved from split capital investment trusts (great structure but ruined by abuses) to structured products a decade or so ago. Essentially, this is just a strategy that pays a fixed return after a set period of time, unless the underlying investment has performed below a certain level.

Typically this could take the form of a fixed payment after 5 years of 35% if the underlying index isn’t below 60% of its starting value at the end of the investment. It’s a straightforward way to concentrate the probability of achieving a particular return and very easy for investors and advisers to understand. If you’re confident an index will outperform this return and are happy to take full market risk, that’s fine, but if you’d rather have a high probability of hitting your investment target, combined with a known capital protection feature, this can be very “smart” investment.

Income Certainty

Sometimes known as a Reverse Convertible (because it’s the “reverse” of a traditional convertible bond which pays a fixed coupon and turns into an equity at maturity if the performance is up) a very popular strategy is to adopt the same structure as that above, but pay out the income during the term rather than in one lump of growth at the end. Investors have the certainty of a known amount of income for a fixed period of time, combined with a clearly defined risk to their capital in return for the higher income.

These used to be known as High Income Bonds (or Precipice Bonds by the press – not because of any particularly precipitous features, but just because it made for better headlines). Current iterations tend to be less “ambitious” and certainly the margins taken by banks, promoters and advisers (normally a fee) are a lot lower than they were in the bad old days. The current low interest rate environment obviously suppresses the coupons available on these, but 5-6% p.a. is pretty attractive when base rates are 0.5%, and many investors are happy to pay the risk price for the level and certainty of income. Expect these passive-plus investments to become more popular as the shambles that will follow current pension reforms unfolds.

Geared Growth

Another popular trade – if a passive investor thinks growth in an index will be above a certain level, why not swap dividend income for enhanced growth and have some capital protection thrown in. Unless you think FTSE growth is going to be 2.5% or less p.a. why wouldn’t you forsake 2.5% dividend income to get 200% of the growth with a cap at 80% after 5 years (unless you’re sure growth will be above 60% or so). Again, a great way to back a given outlook on markets.

As always with structured products, there is a liquid secondary market to allow for changing objectives and market views, although the products are designed to be held for the full term and it’s likely this will be the best strategy to adopt. For more sophisticated investors, the two-way secondary market is becoming bigger by the years and presents many excellent and efficient opportunities for those with the inclination to understand them.

The options above (or the almost limitless alternatives that can be structured) aren’t going to be to everyone’s taste, nor will they always outperform underlying investments, but if there are clearly defined investment objectives, the best delivery method could very well be to use a structured product or should I say: a Smart Beta Strategy!

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