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Why structured products are key to the diversification equation

The definition of diversification and how that applies to structured products

By Ian Lowes, founder of StructuredProductReview.com

A version of this article was first published on the 7th of September 2014 by Fundweb.co.uk:

http://www.fundweb.co.uk/fund-strategy/structured-products/structured-products-smooth-operators/2013619.article

A recent article on diversification within adviser client investment portfolios brought its arguments to a close by stating: "In summary, diversification is fundamentally aimed at reducing sensitivity to downside risk, but at the same time, providing some exposure to market gains"

In terms of a straightforward definition of the nature and benefits of structured investments it is particularly apt.

If we accept that diversification of an investment portfolio is key to reducing risk to the investor, then I would argue that employing structured products should be a consideration for advisers when constructing almost any client investment portfolio. It may be that after consideration other diversification strategies are used but structured products deserve to be a part of the overall equation and a dvisers who take the time to research structured products may find they are opening up their client portfolios to some highly valuable investment options.

This argument is stronger, in my opinion, given the ever-present uncertainty in the markets. Unless you are in the camp that says we are in a bull run that is going to take markets significantly higher in the next five years, structured products with their ability to provide varying levels of protection against downside risk and their ability to deliver equity market-linked returns on the upside, can bring something different to an investment mix.

Let's take the two elements of that quote on diversification and how they apply to structured products. First, 'reducing sensitivity to downside risk'. Almost all the structured investments offered via the advisory market will provide the investor with some degree of capital protection. Commonly, this is to the point where an underlying benchmark has to fall more than 40 or 50% for capital to be affected-in other words, capital is typically protected in all but the most extreme of market conditions. Structured deposits will return 100% of capital unless the counterparty fails, in which case will the deposit falls under the FSCS. Investors therefore can benefit from a differing ways to reduce their investments' sensitivity to market risk.

In respect of 'providing some exposure to market gains', structures offer defined payouts at set dates, dependent on the movement of the underlying benchmark/index–in general the index has to be higher than at the start of the investment for the payout to occur. These enable arange of outcomes to be offered, from fixed percentage returns, through matching the index performance (with, of course, capital protection built in), to geared products that offer a multiple of any rise in the benchmark from the strike point. These can be matched to the investor’s attitude to risk. Knowing what the investor will receive and when in set market scenarios brings a different and valuable element to the portfolio.

Autocalls and defensive plans, I would suggest, are two types of product that have key roles to play if markets remain volatile yet relatively flat over the next 5-6 years.

Autocalls have been the most popular of structured products in the past few years because of their ability to offer high single and double-digit returns per annum and often require the market to have risen a fraction at a set anniversary in order to pay out.

For example, there are autocall products currently available that as well as offering the potential for high single digit returns per annum, as long as the index/indices close at, or above, their respective initial levels, also offer a set percentage return at maturity should the benchmark be down (by as much as 25%) from the strike level. Other autocall products have a reducing reference level as each year passes, i.e. the maturity point of the plan reduces 5% each year after year two – so 95%, 90%, 85% and 80% for years 3, 4, 5 and 6 respectively, thereby increasing the chance of the autocall occurring over the life of the plan.

Another alternative, for those who fear we may be in a bear market in five years time, offers investors the potential for a gross return of 27.5% if the index is above its strike level at maturity or 7.5% if the Index is equal to or below its initial index level at maturity. This is a structured deposit, so it offers 100% capital protection in a falling market (with the proviso as mentioned above).

The range of offers available, and the fact that structured products generally have an average offer period of around six weeks, mean that the structured product market can quickly respond to changes in market sentiment, offering investors products to match their market views.

They also make it a necessity that advisers keep abreast of what’s available in the market.

Returning to the article, its final statement, quoted above, ended by saying: "Given the current market environment, the arguments for multi-asset diversification remain convincing."

I would go a step further and say that as well as looking across assets, a well - diversified and balanced portfolio should have a spread of investment types. Hence, actively managed funds, passive investments (potentially trackers and ETPs) might be considered, and structured products should sit in there also. In this way the investor has a greater chance of a smoother ride on their investment journey.