This is principally a response to demand from investors for steady returns in difficult market conditions, but also a function of the willingness on the part of some investment banks to launch products for pretty much any structured product promoter.
Readers won’t be surprised to learn that some investment banks are less scrupulous than they might be when it comes to choosing the products they get involved with.
For this reason, it is important to have a working level of knowledge of structured products, and how to evaluate them.
Here are the five most important things to look for when determining whether a structured product is suitable for consideration:
1. Counterparty Risk: Pretty much every structured investment you’ll see will rely on a single financial institution delivering the returns offered, in just the same way as a fixed-rate deposit does.
What this means is that seeking a higher return from a riskier bank may mean you lose some – or even all – of the money you invest.
Always be clear about who the counterparty is and what the risks are. Product promoters should be able – and cheerfully willing – to supply you with a sensible commentary on this, including credit ratings and CDS levels (ask for an explanation if you’re not sure how credit default swaps work) and general financial strength.
2. Is the pay-off suitable? Most investors seem to want 100 per cent capital protection and a minimum return of 3 per cent to 4 per cent per annum, plus the chance of making another 5 per cent to 10 per cent on top. But with interest rates at historic lows – normally less than 1 per cent a year, something has to give.
If anyone offers you this kind of return, be very wary indeed.
Higher returns come with either a lower probability of achieving them, or more risk to capital, or both, and this is needs to be fully understood.
Based on underlying interest rates, a 7-per-cent return today over five years is equivalent to a return of around 25 per cent five or six years ago with regard to the level of risk and the probability of achieving it.
3. Scrutinise the risk level: A lot of structured products are designed with one aim in mind: to make as much money as possible for the bank.
To achieve this, a product’s creator must strike a balance between making the product attractive enough to sell, while also building in as big a profit margin as possible.
In the rush for higher headline rates, some products link to the worst of a basket of underlying shares, rather than to an index. These products can be incredibly risky; we can all think of large companies that have disappeared completely, or seen massive drops in their share price.
It is important that you are clear about the level of risk you’re taking on. If an investor is unlikely to make a large investment directly into the shares of one company, it would be inappropriate for them to invest in the shares of the worst-performing company out of five.
4. Liquidity is paramount: Any investment is worth only what it can be sold for. Recent years have shown the importance of investing in assets that are priced on a “mark to market” basis rather than a “mark to model” basis.
What this means is that the bid price of an investment reflects the price it can be sold for – either because it’s listed and market makers will offer a price, or because this is a firm price that will be paid by the issuing bank (in the case of most structured products).
Mark to model pricing involves the investment manager, promoter or administrator making assumptions about the value of assets, and converting this into a price for investors. This can be a useful way of valuing property assets, for example, but valuation methods vary considerably.
Pretty much every structured product should be valued on a mark to market basis, and should offer regular liquidity to investors. There should be no restrictions on sales and no lock-in periods. If there are, it’s worth checking a bit further.
5. Reputation counts: If you’re still reading this, you’ll be familiar with a number of investments that have failed, sometimes spectacularly. Remember traded endowment funds, geared with-profit funds, life settlement funds? Certain forestry timber funds, mortgage funds, property development funds?
What’s surprising is that some product developers and promoters seem to move from one investment that looks great, but collapses in chaos, to another that does the same.
If you buy a structured product from a bank (or its distributor) that has a track record of promoting disappointing investments, don’t be surprised if your purchase, too, turns out to be a poor investment.
Clive Moore is managing director of Investment Design and Distribution. Article supplied through Jerry Dingley of Property Portfolio Services. Dingley and business partner Tim Whiteley have a combined 50 years of experience advising expatriates & international investors both onshore UK and in the Asia Pacific region. info@qropspensioncentre.com
Note: This article contains general information only and is not intended to be taken as financial advisory, investment, or tax advice.