Chris Taylor talks about the overlooked ‘investing by contract’ benefits of structured products
When it comes to structured products, the most obvious risk is well-known to be the 'counterparty risk', i.e. the risk that the bank behind a product can go bust and cause loss of capital. But rather than add more column inches to stating that advisers and investors should always ensure that they are cognisant of this risk, I'd like to flip the point on its head and talk about an overlooked point, which is 'the contract benefit' – as opposed to the risk – of the counterparty banks behind structured products!
The basic risk of structured products is that the counterparty banks must stay in business – but their major benefit is that they equate to 'investing by contract' and the contracts can remove or reduce some key risks that many investors naturally want to avoid… but have often been 'educated' to think that they can't.
Most specifically, structured products can remove or reduce 'market downside risk', i.e. the risk of markets going down and investors losing capital.
In addition they can also remove or reduce 'market upside risk', i.e. the risk that markets don't go up and generate the returns investors need.
But perhaps more interestingly, structured products can remove 'active fund management process risk', i.e. the risk that active fund management doesn't deliver the performance, or the risk control, that it marketed itself as being capable of providing (noting that the marketing of actively managed funds is actually based on nothing more than aims and objectives, or hopes, not legally binding contracts!).
The fact is that the counterparty banks behind structured products take on risks that exist in other types of investments, such as mutual funds, and turn them on their heads… by legally and contractually defining both risk and return. And the contracts mean that the process risk falls on the counterparties, not investors.
And that is the eureka point… that structured products equate to 'investing by contract'.
Investors in structured products basically delegate the process risk of investing to a major investment bank, the counterparty, which becomes legally obligated to deliver the terms of the contract at maturity, regardless of their process, unless they are bust.
This is a major benefit of structured products, but it is being overlooked by some advisers and investors, because they're only focusing on the obvious risks, not the less obvious benefits.
Yes, the process behind a structured product may involve some 'clever stuff', in order for the counterparty bank to 'hedge' their legal obligation to deliver the terms of the products they issue, at maturity.
But investors in structured products are not investing into the counterparty's process – unlike active fund management, where if a fund manager's process fails it's the investor who carries the risk and suffers.
Investors in structured products are investing in contracts! And the contracts are usually issued by some of the world's strongest financial institutions, who take the process risk of investing away from the investor and carry and own the risk themselves.
Investors in structured products therefore have very different considerations to investors in active funds.
"The fact is that the counterparty banks behind structured product take on risks that exist in other types of investments, such as mutual funds, and turn them on their heads… by contractually defining both market risk and return. And the contracts mean that the process risk falls on the counterparties, not investors."
The key consideration is the strength of the bank behind the product and whether they will still be in business at maturity – and, of course, the world's biggest banks like to stay in business, and governments, central banks, regulators, shareholders, deposit holders, employees, etc. also like them to!
There is no such thing as a perfect investment. As with any investment, there are risks that need to be understood with structured products. However, many investors may find it easier to consider whether a major global bank is likely to stay in business, than what may or may not happen to the stock market. And many investor portfolios may benefit from the contract benefits of structured products, particularly in a challenging market environment.
A good approach to portfolio construction is to diversify across various types of investments, as well as considering asset class and geography.In other words to align: the best of active funds; the best of passive funds (pretty much everybody seems to like passive and smart beta these days!); AND the best of structured products… especially because there are some things that active and passive funds can't do, that structured products do… and do by contract.
Matured structured products performance facts:
StructuredProductReview reviewed all structured products which matured over 10 years between January 2009 – December 2018:
- 3670 structured products matured.
- 3613 (98.45%) generated positive returns or repaid capital.
- The average return of all maturing products was 6.23% p.a.
- The average return of all maturing capital-at-risk products was 7.9% p.a.
- The average return of all maturing capital-at-risk kick-out products was 8.55% p.a.
- Only 57 (1.55%) maturing structured products created a loss for investors
- Only 5 of these loss-producing products were single index, linked to the FTSE 100
- The average duration of all maturing structured products was 3.78 years
These past performance facts clearly evidence the potential virtues, merits and efficacy of investors including structured products in diversified and balanced portfolios.
Particularly in a challenging market environment, it may be hard to identify investment funds or products more likely to deliver strong positive returns than 'best of breed' structured products, especially those which are designed to generate positive returns without requiring the stock market to rise, with a defined level of protection if the stock market falls.