Structured investments designed to limit downside risk
South Africans face an enormous range of choices when deciding how and where to invest in the financial markets. If they invest in unit trusts, they need to choose a manager, decide which strategies best suit their investment needs, and the currencies or regions in which they want to invest.
Japie Lubbe from Investec Structured Products says outcomes and performance among different fund managers and regions can vary significantly. And if markets crash, as they did in 2008, all funds with equity exposure are affected.
He says these challenges are causing many South African investors to look at structured products, which use financial instruments to create predetermined parameters for how an investment will behave over a certain period.
“They do this by investing in a combination of bonds and share options. The invested capital is protected by the bond maturity value, while the options provide exposure to any potential upside.”
Lubbe says the key issue is determining the balance between risk and reward.
“We consider prevailing market views, historical market performance and typical investor risk appetite to decide how much capital we want to protect, and, on the other hand, the amount of upside we want to target.”
He adds that investing in this kind of product requires a different kind of thinking. Instead of hunting for value in a market or trying to analyse which manager is most likely to perform in the future, investors are presented with set possibilities, and they need to decide whether these meet their desired outcomes.
Lubbe says an example is the Investec Offshore Protected Share, which is open for investment and provides exposure to a selection of international indices, including 40% to the S&P 500 in the United States, 15% to the Nikkei 225 in Japan, 30% to the EuroStoxx 50 and 15% to the MSCI Emerging Markets Index.
The product offers investors a minimum return of 4% in US dollars if these markets are down or flat over a five-year term. If they are up, investors will enjoy double the growth up to a total maximum of 50%, which would represent an annualised return of 8.45%, also in dollars.
“With structured products, rather than running all the risk of not knowing the outcomes, you are investing in something that has been designed with all the probabilities taken into account. You do, however, still take on risk, which is that the bond issuer defaults,” Lubbe says.
He says the big advantage for investors is that this means you are able to determine beforehand whether the investment is likely to meet your objectives.
Lubbe recommends that these products make up only 10% to 15% of your portfolio so that you are not over-exposed to credit risk, particularly in the current market conditions. However, where uncertainty is high, structured products can provide a degree of security within a portfolio.
“Investors are used to a world where they just have to take their chances, and whether the market goes up or down they just have to be happy.
“But with structured products, the range of outcomes is limited. The investor can decide whether they are prepared to accept this range,” Lubbe says.