This article was first published in the third-quarter 2015 edition of Personal Finance magazine.
How would you like to invest in four foreign stock markets with the benefit, from the start, of being most exposed to the one that will perform best, or with the promise of doubling your money if the European market goes up? And if markets go down, you would be assured of getting back all your capital after fees.
These are the kinds of promises that are made when you invest in a structured product, which typically guarantees all or part of your capital and which may offer you an enhanced, or geared, return based on the performance of an index. However, both of these depend on your remaining invested for a term, usually three to five years. The return is typically referred to as the payoff.
The products differ across providers, presenting a wide variety of choice. In addition, structured pro-ducts are offered in tranches, and if you miss an offer, the next one for the same product may be slightly different if market conditions have changed.
Structured products first appeared in South Africa in the late 1990s, but the crash in technology stocks in the early 2000s, as well as high costs, vague marketing material and unknown exposure to currency risk, resulted in many investors becoming disenchanted. In recent years, structured products tailored for individual investors have reappeared, with both life assurance companies and banks offering tranches and some evidence that they have learned some of the lessons of the past. Ryan Sydow, the head of retail structured and risk solutions at Absa, says the new products are cost competitive, the marketing material is clear, concise and transparent, and it has become easier to liquidate your investment.
Structured products are a form of passive investing, because the payoffs are based on an index. The enhanced returns that some products offer address the criticism that passive investments will never beat the market, Sydow says.
Many products are now listed on the JSE and are priced daily, although this does not mean they are available to trade, because they are meant to be held to maturity. There are now two ways to own structured products: directly, if you have a stockbroking account, or through a life assurer’s endowment policy, which may offer tax and estate duty benefits.
As a result of these improvements, structured products are also appearing on investment platforms that offer access to shares and unit trust funds. Earlier this year, iTransact, a platform offering index-tracking investments that are accessed through financial advisers, launched iStructure, a platform dedicated to structured products.
Although the latest products may be more transparent than their predecessors, it is still important to know how structured products work, what the guarantees and enhancements cost, and whether you really need them.
The benefit of hindsight
Momentum Wealth, a long-time provider of structured products in the MMI Group, in 2014 launched the Momentum Global Growth Allocator. Nine tranches have been offered since then. The product is marketed as giving you “the benefit of hindsight” when determining how much of your portfolio to allocate to each of four global market indices, and if your total returns over the investment period are positive, your returns will be boosted by as much as 25 percent of that positive return.
It works like this: you invest for five years on the understanding that, at the end of the term, you will benefit from the returns of the:
* Standard & Poor’s 500 Index, which tracks the top 500 shares by market capitalisation on the New York or Nasdaq stock exchanges;
* Euro Stoxx 50 Index, which tracks the top 50 shares by market capitalisation and liquidity in the euro zone;
* Hang Seng Index, which tracks the largest shares by market capitalisation on the Hong Kong stock exchange; and
* BNP Paribas Africa Equities Funds Excess Return Index, which tracks leading mutual funds invested in African equity markets.
At the end of the five-year term, the indices are sorted from best to worst performance, and you receive the relevant returns of each index, but the product “allocates” the biggest portion of the payoff to the return of the better-performing indices, Andre Botma, the senior product developer at Momentum Wealth, says. Forty percent of your investment is allocated to the best-performing index, 30 percent to the second-best-performing index, 20 percent to the third-best-performing index and 10 percent to the worst-performing index.
In addition to benefiting from higher allocations to the better-performing indices, if the overall return of the ranked indices is positive, the payoff will be boosted further by a targeted 25 percent of that return, with this amount confirmed at maturity. For example, Botma says, if, with the benefit of hindsight, the return of the weighted indices is 50 percent, your return will be boosted by 25 percent of this return, or 12.5 percent. This means you will enjoy a total return on the product of 62.5 percent.
In addition to these defined payoffs, if the performance of the four markets is such that the payoff is negative, your capital will be protected, and you will get back the rand amount you invested before any costs were deducted.
According to Momentum, the investment was back-tested against a blend of the four indices, with each accorded an equal weighting, as well as against the average returns of actively managed funds in Morningstar’s global equity large cap blend sub-category. The Global Growth Allocator out-performed 100 percent of the time, Botma says.
The product forms part of what Momentum refers to as its core protected investment offering on the Momentum Wealth platform.
Momentum also offers a Protected Index Plan that guarantees you the return of the FTSE/JSE Top 40 Index up to a limit, or cap, such as 58 percent, over a term of three-and-a-half years. If the return of the index is negative, you will at least get back your capital. The limit on the return you can earn from the index depends on the market conditions when the tranche is offered.
Another life assurer that offers structured products is Discovery Invest. One of its first products was RightChoice, which it offered as either what it referred to as “a protected equity” or “a protected asset allocation” investment. The product was marketed as enabling you to derive the benefit of selecting from a choice of three equity funds, or three asset allocation portfolios, that would perform best.
The equity product offered the return of the Discovery Equity Fund, unless the fund was out-performed by either the Top 40 Index or an equally weighted benchmark of three alternative equity funds: the Allan Gray Equity Fund, the Nedgroup Rainmaker Fund and the Coronation Equity Fund. If either of these two benchmarks out-performed the Equity Fund, the RightChoice product would pay you the return of the fund, plus 75 percent of the out-performance achieved by the relevant benchmark.
The RightChoice asset allocation protector offered you the returns of a conservative, a moderate or an aggressive multi-asset portfolio, depending which of the three performed best over five years.
According to Discovery, the May 2010 tranche of the asset allocation protector that matured in May 2015 had a return of 9.7 percent a year (the compound return).
Earlier in 2015, Discovery launched a new structured product, the Capital 200+, which offers to double your investment if the returns of a global portfolio of the Euro Stoxx 50 (70 percent of the portfolio) and the S&P 500 (30 percent) are flat (no return) or positive. If the returns are negative, but the loss is less than 50 percent of your capital, you will get back your capital. If your losses are greater, you are fully exposed to the loss (that is, a loss of 55 percent if the market loses 55 percent).
The global portfolio can be flat or up by a mere 0.00001 percent after five years to double your capital – effectively giving you a guaranteed return of close to 15 percent a year over five years before tax, Discovery says. If the portfolio provides you with a cumulative return of more than 100 percent over five years, your original investment will be doubled and you will earn the return in excess of 100 percent on top of that.
The Capital 200+ has been going for only a few months, but so far, both the Euro Stoxx 50 and the S&P 500 are up and investors are on track to double their money, Craig Sher, the head of research and product development at Discovery Invest, says.
Life assurers such as Momentum and Discovery house their structured products within endowment policies with five-year terms, which means that the life assurer pays capital gains tax of 10 percent. Momentum’s structured products are also available in its retirement annuities (which are subject to regulation 28 of the Pension Funds Act), preservation funds and living annuities.
In the first five years, endowment policyholders are allowed to make one withdrawal equal to their contributions, plus investment growth of up to five percent a year compounded. In some cases, life assurers will also allow you take an interest-bearing loan from an endowment policy.
Both Momentum and Discovery say you can get out of the contract before the five years are up, but this could result in a capital loss if the indices are performing badly, because you would get back only the market value of the underlying instruments (see “How they work”, below). The capital protection applies only if you remain invested for the full term.
These products are based on what are known as structured notes, which the life assurer buys from banks and holds on your behalf.
Banks have been offering over-the-counter structured notes for some time, but now they are offering notes listed on the JSE, known as credit-linked financial instruments, which you can hold in your own name either through a stockbroker’s account or by investing through a linked-investment services provider. Some have terms of less than five years. Local banks Absa, Investec and Rand Merchant Bank, as well as French banks BNP Paribas and Société Générale, are the main providers of structured notes.
Although the products are priced daily, the price is based on the value of the underlying instruments when they are priced – and this is what you will get when you sell on any day before the end of the term. This is not an accurate reflection of what you will get if you stay invested for the term. The only time the price of the instruments will exactly equal the performance of the markets multiplied by the payoff is on the maturity date, Sydow says.
In addition to the price you would receive if you sold the product on any day before maturity, Absa publishes an indicative maturity value for its structured products that reflects the value as it would be if the product matured on the date of publication of the indicative value. Absa’s indicative value cannot provide you with any indication of what may happen to the index in the future, so it is based on the assumption that the price does not change between the indicative value date and the maturity date.
Brian McMillan, a specialist in structured products at Investec Structured Products, says if the product has an enhanced, or geared, return – that is, it offers a return that is a multiple of an index – you will start to see the enhanced, or geared, return reflected in the price only in the last few months of the term.
He says daily pricing of the bank’s JSE-listed structured products means that, if you have to sell your investment before the term is up, you can see what you will receive. The market value may be higher or lower than your original investment, and any selling costs or taxes will be deducted, he says. Again, any capital guarantee applies only if you hold the investment to maturity.
Double your money
Earlier in 2015, Investec Bank offered a tranche of a product called the Euro Stoxx 50 Multiplier. This product offers you returns 10 times the first 10-percent return of the Euro Stoxx 50 in rands at the end of a term of three years and nine months. This means that, if the index return is 12 percent at the end of the term, the most you will receive is double your money (10 times the 10 percent limit, or 100 percent).
It also means that, if the index moves up only 3.2 percent, you receive a return of 32 percent. Investec says if you were invested in the index itself, the index would have to double to out-perform the Euro Stoxx 50 Multiplier. Like most structured pro-ducts, the Euro Stoxx 50 Multiplier offers a form of capital protection if the index falls.
The product was launched amid fears that growth in European markets would be muted. This was the reason for offering the multiplier to gear your return, McMillan says. “The great thing about the gearing is that the Euro Stoxx 50 Index needs to increase by only 10 percent over the 3.75 years for investors to double their investments in rands,” he says. Similarly, the index would have to fall by more than half (50 percent) before your capital was at risk, he says.
The Euro Stoxx 50 Multiplier is one of a number of structured products that Investec has put together in recent years. It has other structured products that track foreign indices, but are denominated and deliver returns in rands, as well as products based on foreign indices that are denominated in foreign currencies. In 2012, for example, Investec offered the S&P 500 Growth ESP structured product and the S&P Rand Autocall.
The S&P Growth ESP is a three-and-a-half-year listed investment that offers investors 100-percent protection of the rand amount invested, as well as a return of 1.1 times the percentage increase in the level of the S&P 500 in US dollars, with no cap. In January in 2015, two-and-a-half years into the investment, the index had a return of 48 percent in US dollars, and investors stood to gain 92.92 percent in rands (1.1 times the index return, plus the rand/dollar exchange rate).
The S&P Rand Autocall was a three-year investment that offered an enhanced return of 11 percent on the index if the S&P 500 was positive or flat and a 100-percent capital guarantee if the index fell by up to 30 percent. This product expired in its first year, giving investors a return of 11 percent.
Late in 2014, Investec also offered a structured product based on the Top 40. The Top40 Accelerator will provide the return of the index multiplied one-and-a-half times, to a maximum of 60 percent. Your capital is protected against market falls of up to 20 percent over the five-year period. This means that, if the Top 40 Index has fallen by up to 20 percent at the maturity of the product, you get back all the capital you invested (including your costs), but if the fall is greater than 20 percent, your capital will be reduced by the percentage of the loss that exceeds 20 percent. So if the loss is 25 percent, you will get back your capital with a loss of five percent.
McMillan says more tranches of the Top40 Accelerator can be expected. The terms may vary, depending on Investec’s view of the market. While last year’s tranche offered protection against a fall in the index of up to 20 percent, if the market is looking expensive, Investec may revise the protection to cover market falls of up to 25 percent, he says.
Filtering enhanced returns
Absa Bank is also offering a number of listed structured products covering local and global equities, as well as commodities. Its offerings include products based on smart beta indices – indices that are not based on the market capitalisation of shares, but include filters aimed at enhancing returns.
Absa’s Global Equity Protector offers a capital guarantee with exposure to the Barclays Black Chip Price Return Index. This is a smart index that uses filters to distinguish higher-quality shares among what are typically regarded as quality, or blue-chip, shares. The filters used by Absa to determine the black-chip shares are: financial robustness, liquidity, debt to earnings and dividends.
According to an update published by Absa on its website at the end of May 2015, the Global Equity Protector Black Chip Issue 1, with a 100-percent capital guarantee and 29 months to maturity, had an indicative maturity value that showed a return of 31.48 percent, while one with 42 months to maturity showed no return, because the index has returned only 1.44 percent.
A tranche of the Global Equity Protector Black Chip with an enhanced return, but without the full capital guarantee and 29 months to maturity, was showing a 47.23-percent return at the end of May 2015.
Sydow says that, for some time now, research by Barclays has pointed to more upside potential from offshore stock markets, and its product offering has reflected this. Absa’s structured products offer investors a good way to increase their exposure to offshore equities in their overall asset allocation without taking on the risk to their capital, he says. Absa’s latest offshore-market structured product offering is based on a multi-asset index put together by Barclays.
Absa’s Diversified Commodity Protector, last offered about three years ago, provided exposure to a diverse basket of commodities, with the potential to earn 100 percent of the growth of the basket and a guarantee of a minimum return of at least 15 percent at the end of the four-year term. The Diversified Commodity Protector was offered to South African investors as a safe platform from which to access exposure to commodities in the hope of superior returns. These returns did not materialise, but investors benefited from the protection offered.
Absa currently has a structured product based on the Top 40 Index that offers a 100-percent capital guarantee, with the return from the index capped at 60 percent. One tranche of this product matured recently after four years. The final index level (which includes some averaging of values over the last year of the life of the product) was 68 percent, so the product returned 60 percent over four years, or 15 percent a year.
Sydow says the top-performing unit trust fund in the South African equity large-cap sub-category (funds that invest mainly in the biggest shares by market capitalisation) was the Absa Large Cap Fund, with an annual return of 16.34 percent over the four-year period. But most funds in the sub-category delivered a return of less than 15 percent a year. The average return was 14.72 percent a year over the four-year period. He says this means that investors who chose an investment with a guarantee earned a better return than the average investor in the unprotected unit trusts. They gave up two percent of performance a year from the index to enjoy the peace of mind that comes with investing with a guarantee, he says.
Both Absa and Investec provide products for the iStructure platform, which accepts minimum investments of R10 000, whereas most structured products for retail investors require a minimum of R50 000 or even R100 000.
iStructure is a natural progression from iTransact, a platform offering exchange traded funds (ETFs) and exchange traded notes (ETNs) to investors through a network of financial advisers, Lance Solms, iTransact’s director, says. The new platform is aimed at people who want to invest in ETFs but are concerned about the level of the market and want some protection, he says. For example, he says, if you bought an investment that tracked the Top 40 Index, you would have enjoyed a very good run over the past six years. If you become concerned about the price of the shares in this index but do not want to disinvest, you may want to consider a structured product, particularly if your investment time horizon has shortened.
Initially, the structured products offered by the four banks will be linked to the performance of well-known indices or stocks, such as the Top 40 Index or the Top 20 Global Brands, but there are plans to diversify at a later stage, Solms says.
The four structured products that iStructure were offering at the time of writing, in June 2015, were:
* Société Générale. A product that offers the growth in the Top 40 Index to a maximum of nine percent a month when the index has been moving up, or the returns of a hypothetical fixed deposit that yields nine percent a year when the index has been moving down, plus 100-percent capital protection.
* BNP Paribas Global Brand Leaders. A product that offers 140 percent of the growth you would earn if you invested in a portfolio of 20 global brands, including Google, Apple and Walt Disney (the Global Brands Basket), with all your capital guaranteed if the value of the portfolio falls by up to 50 percent.
* Investec Top 40 Wealth Accumulator. The performance of the Top 40 Index, up to 20 percent a year and including a 100-percent capital guarantee.
* Absa Capital Twin Win. The performance of the Top 40 Index, or the inverted positive performance of the Top 40 if it drops by up to 40 percent. If the index closes lower than 40 percent below its starting point, you simply get the return of the index.
All these products have a term of five years, as will most of the products launched in future, although some will have shorter terms. Solms says the iStructure products will be available in an endowment, because there are estate-planning benefits to putting the structured products in these policies. With an endowment, you can name a beneficiary, and if you die before the investment matures, the structured product can stay in place and pass on to the beneficiary.
iStructure’s endowments are from Africa Unity Insurance, in which PSG holds the majority shareholding.
How do these products work?
How can Momentum offer you the benefit of the highest allocation to the best performing of four indices, or Discovery offer to double your capital if a portfolio based on the Euro Stoxx 50 and the S&P 500 is flat or up only marginally? And how do structured products protect your capital?
The answer is that they do not invest in the index on which the returns are based, but are made up of two parts: an investment in a bond and an equity option. To provide the capital protection or guarantee, a structured product typically, but not always, invests in a zero-coupon bond, which the provider buys for less than your capital investment, but which pays out 100 percent of your capital after five years. Sydow says the zero-coupon bond costs 65c today for every 100c it pays out on maturity five years later. The balance of your investment is used to pay fees and to buy one or more equity options.
An equity option gives the product provider the right, but not the obligation, to buy (a call option) or sell (a put option) a quantity of shares at a set price (strike price), within a certain period of time (before the expiry date). Sydow says many varieties of options are used to provide the different payoffs of structured products. The equity option is exercised only if the relevant index shows a gain.
For example, a structured product offering to deliver the positive performance of the Top 40 Index and your capital back if the index is negative will use a call option on the index. This option is exercised only if the index is positive at the end of the term. If it is not, you receive only the proceeds of the zero- coupon bond, or your capital, back.
When the protection offered is that you will get back 100 percent of your capital, there is less to spend on options providing the returns, or the payoff. If your capital is not guaranteed for all market falls, you will typically earn an enhanced, or geared, return. Investec can offer its Euro Stoxx 50 Multiplier, because investors take the risk that, if markets fall by more than 50 percent, they will lose some of their capital. Why, you may ask, would you want a product that offers a guarantee only if the market falls by less than 50 percent? Surely, the risk of it falling more is exactly why you would want the capital guarantee? McMillan says a market crash of more than 50 percent is highly unlikely, so there is little need for such a guarantee.
Another way a structured product may offer an enhanced return is by capping the return of the index, for example, at nine percent a month or a cumulative return of 40 or 60 percent. If the index returns more than this cap, the balance is used to buy the option that enhances your return. In an online guide to structured products, Absa explains that you should accept a geared-return product that caps your growth if you are expecting the market to rise modestly over the investment period, so you will gain from the gearing without losing because of the cap.
Structured products can also be set up to deliver a minimum return on maturity, but this is at the price of reduced exposure to the chosen index. Sydow says these products will either cap your maximum return or you will receive less than the index return as a payoff. These investments are often most appropriate to the cautious investor seeking to gain some equity exposure, but with some of the return guaranteed.
Some products offer a simple fixed return if a condition is satisfied at maturity – for example, a return of 45 percent after five years if the chosen index is at least equal to its starting level at maturity. Typically, if the condition is not met, the original capital is returned in full. According to Absa Capital, this is an “all or nothing” type of investment, but if it is successful, investors can benefit considerably over alternative investments such as deposits. Some products lock in a gain periodically over the life of the product, Sydow says.
What is missing?
The biggest drawback of structured pro-ducts is that you may not earn the dividends you could receive if you invested in the index itself.
Sher says that, where you do not earn the dividends of the indices on which the structured product is based, the distributions are used to provide the enhanced payouts and guarantees that the product offers when it matures.
Sydow says the dividends are taken into account when the price of the call options is set, but it is correct that you do not receive the dividends directly.
Another consideration is that, if the structured product offers a rand return from an offshore index, you will not benefit from any depreciation in the currency. Conversely, Sher says, you are protected if the rand strengthens against the relevant currency of the index on which the structured product is based.
If you want to evaluate whether a structured product will offer you value, consider the dividends you are giving up, McMillan says. For example, compare the annual dividend yield of the Deutsche Bank Euro Stoxx 50 x-tracker and adjust for exposure to this index in rands only. If the dividend yield is 2.5 percent a year, he says, it means an investor will be giving up a possible 7.5 percent over a three-year period. However, many ETFs charge fees that reduce the dividend yield, and investors need to take this into account. Similarly, investors need to consider what it would cost to buy a put option on the S&P for three years – typically about 14 percent of your investment.
McMillan says Investec is continually looking for value in the world’s markets and in option prices when it designs structured products, so the products are intended to provide you with a better return than the market, but if the market does not perform as expected, at least your capital is protected.
Rob Rusconi, an independent actuary known for his research into the high costs of retirement savings, says structured products often do not state clearly that you will earn only the growth in the index price and not the dividends you would earn if you invested in a simple index-tracking investment.
Rusconi also says that none of the product providers warn investors that, with products with overseas exposure, the provider will make part of its profits from the expected deterioration of the rand relative to the currency of the offshore index. The providers make these gains upfront, because they buy derivatives to provide the products’ return profile and protection upfront. They are unlikely to take any material risks on their balance sheets, he says.
Sydow disagrees. He says banks manage and hedge the risks over the term of the product, but investors receive their payoff as long as the bank still exists at the end of the term. Sher, too, disagrees with Rusconi. He says Discovery does not earn any profits from exchange rate movements and earns its income from annual fees in the same way as other funds do.
What is the cost?
When it comes to costs, there is little transparency, because most of the costs are built into the payoff, or return, you are quoted. The provider builds in profitability based on the cost of the derivatives and other underlying investments.
With the Retail Distribution Review on the way, Sydow says it is likely that structured products will in future be “clean priced”, meaning that all fees will be taken off before the structured products are issued. In this case, the fees will be deducted first and the capital protection will only be remainder – for example, R95 of each R100 invested.
Currently, Sydow says that, for every R1 you invest, 65c is spent on the zero coupon bonds, between five and eight cents is spent on fees, and the balance funds the options.
Botma says Momentum’s costs include an advice fee of 3.42 percent, plus 4.56 percent for Momentum, adding up to a total fee of eight percent for the five-year period.
McMillan says that annual fees of between one and 1.65 percent are built into the product.
You may also have to pay an investment platform fee, the cost of the endowment and the advice fee.
Solms says the investment platform administration fees for iStructure are 0.35 percent a year, or 1.75 percent over five years. The endowment will cost you 0.4 percent a year, or two percent over five years. The total cost is 3.75 percent, or 0.75 percent a year.
Solms says financial advisers can take between 1.14 percent and 3.42 percent, but, on average, their fees are 1.71 percent. He says that, at this average fee, the total fee will be 5.46 percent for the five years.
With a maximum advice fee of 3.42 percent, Botma says, the total fee is 7.17 percent, and this translates into 1.43 percent a year, which compares favourably with the total expense ratios of equity or balanced collective investment scheme funds (excluding advice and investment platform fees). He says this is particularly favourable once you consider that the iStructure fee includes guarantees, the platform administration fee and the advice fee.
Solms says if the total fee is 5.46 percent and is paid before you buy listed structured products, the fee would be R546 on an investment of R10 000 before the shares are purchased. In that case, if you redeem your investment before the end of the five-year term, you will receive the market value of your shares at the time, without any further penalties or charges.
The fee can also be embedded in the structure, which means it is reflected in the price of the listed product. In that case, if you redeem your investment before the end of the five-year term, you will receive the market value of your shares less the fees incurred.
Financial advisers who sell you a structured product should have a licence to advise you on discretionary investments. If the structured product is housed in an endowment policy, an adviser with a licence to sell life assurance products can sell it.
Do you need the guarantees?
In a recent publication, Long Term Perspectives, Old Mutual Investment Group shows that, over all rolling five-year and 10-year periods since 1925, no investors lost money in the local equity market, as measured by the FTSE/JSE All Share Index. Over rolling three-year periods since 1925, investors in the JSE lost money 10 percent of the time. Therefore, it is unnecessary for long-term investors to pay for guarantees; guarantees are useful only if your investment horizon is shorter than five years.
Sher says this is not true for all indices. Sydow says investors with low resilience to risk do not always stay in the equity market; they run for the hills at the first sign of trouble and may, therefore, find some form of capital protection useful.
Who should invest?
Rusconi says long-term investors should definitely be invested in the equity market, without having to forgo dividends or pay for capital guarantees. However, investors with a shorter-term horizon, who want higher returns than a bank investment, may find value in investing in a product that provides a cap on performance in return for a guarantee, he says. The suitability of the products depends on your appetite for risk and your circumstances.
However, Rusconi says that, even when you know you need the insurance of a guarantee, you should be able to evaluate the cost you will pay for that insurance, and structured products typically do not enable you to do that. You are unable to assess what it costs you to give up dividends and depreciation in the rand and accept a limit on performance.
Even if you were given information about the likelihood of market returns resulting in a loss, or performing above the limit, you would still struggle to weigh up what you stand to lose against what you stand to gain. In other words, it is almost impossible to know what you are giving up to the product provider in return for the protection or potential gain.
Consequently, Rusconi says it is questionable whether these products will pass the test of Treating Customers Fairly (TCF) once TCF is fully implemented. If you could compare the products to the relevant index, you would know what you were giving up in order to gain each extension to the product. So, for example, if the product has a guarantee only, the cost of this guarantee may be the dividends. If it has a guarantee and a performance enhancer, you will probably find that it also has a limit on the returns you can earn from the index, Rusconi says.
But Solms is of the view that listed structured products do pass the TCF test, because they are valued daily and meet the requirements of both the Financial Advisory and Intermediary Services Act and the JSE’s listing requirements.
Sydow points out that structured products have survived in places such as the United Kingdom, where TCF is already in operation.
Despite his criticisms, Rusconi admits that he once used a structured product sold by a bank in the UK, because he wanted to leave funds invested in the market, but he feared that the markets were high. Rusconi says his fears were never realised, but he did not regret buying the product, because, by giving him peace of mind, it met his requirements at the time.
Solms says most investments are suited to the long-term investor. Yet many people have short-term investment needs, such as providing for a child to go to university in five years’ time. Structured products are good for people with these short-term needs and provide them with the assurance that they will not lose money, he says.
Sydow says structured products are under-utilised in the South African retail market compared with the markets in Europe and the US, although they suit a range of investors, because they can be customised to individual needs and have explicit capital protection.
He says you should consider the risk-adjusted potential of the product you are buying. For example, buying something that could give you a 100-percent return in five years’ time may sound good, but if views are divided on the growth outlook on the market, you face a 50-percent chance of getting no return in five years.
Ideally, you should take advice from an financial adviser when you invest in a structured product. The adviser should be able to backtest the product and assess how it might perform under various future scenarios. Although you have no indication of the return on an investment in an ordinary index or actively managed unit trust fund, you know what the payoff in a structured product is, Sydow says. You also know to which markets the product is linked. What you need to consider is the circumstances under which the investment will be a good one for your goals and then agree on the scenarios that are most likely to pan out, he says.
Before you invest, he suggests you ask the product provider to show you the research it has done on the relevant market and to explain why it believes the product as it is structured will deliver a good return for you.
According to McMillan, Investec’s structured products are bought by high-net-worth investors who know what they are giving up, but are looking for protection on investments with a three- to five-year horizon. Structured products take a view on the market, and the people who buy them share that view.
Sher says products such as Discovery’s Capital 200+, which have a guarantee on capital of up to a 50-percent decline in the indices, are not for people who want a product, such as cash, which will almost always deliver 100 percent of your capital. He says the level of protection offered on a structured product with a partial guarantee is aimed at covering the most likely declines in the relevant markets. Back-testing of the Euro Stoxx 50 revealed that it had not fallen by more than 50 percent over any five-year period – not even during the financial crisis of 2008/9.
Before you invest, you should check the credit rating of the banks that provide the underlying assets, Sydow says, because you are taking what is known as counterparty risk – the risk that the provider of the underlying bond or derivative may not pay out. He says iStructure and the banks themselves provide the credit rating of each bank that offers the underlying investments, and you can establish them for yourself.
McMillan says credit risk is not a huge concern, because none of South Africa’s banks failed during the recent financial crisis. But if the structured product market grows strongly, people making large investments would be wise to diversify across the banks.
The value, or lack of value, of the latest products may be apparent only in years to come. There may well be a need for well-constructed products with capital guarantees and performance enhancers, but only astute investors and/or advisers will be able to discern which products are appropriate for you.