Researching Structured Retail Products: 10 Tips

Janine Starks

Janine Starks is Head of Investment Solutions at Liontamer.

Before joining the team Janine worked for UK based advisory firm Chase de Vere (Investment IFA of the year 2002, in Britain), where she headed up the product development and research areas of the business and was an independent commentator in the personal finance market for many years. Janine was also actively involved in the development of many of the UK's new and innovative capital protected products. She has written this article based on her own experience of dealing with these products in the advisory market.

As more and more structured retail products are launched into the New Zealand market, financial planners will question how they should select and research products. Once the structure is designed, the risks and returns are very transparent and easy to understand. However, the one thing that constantly changes are the terms offered. As each tranche comes to market, you see different terms, participation rates, and varying degrees of capital security.

To research these products we need to get a good grip on their structure - what are the returns being promised? And what are the risks involved? To find out, you simply need to pull apart the individual features and have a broad understanding of how market conditions can affect the terms being offered.

Below you will find 10 tips and a number of useful examples which will start to give you a good idea of what to look for.




1. Capital security

a) Full or partial protection?

We need to get under the bonnet and figure out what happens to a client's investment when the sharemarket index or asset it is linked to, goes down. The simplest investments offer full protection at maturity. Other structures offer less capital protection - not because they are worse investments, but because they are doing so as a trade off for higher potential rewards. There are four main types of capital protection and all are very simple to understand. Not all of these have been seen in NZ yet, but innovation continues and it's good to have a head start.

• Full protection - if the market declines, the investor receives a full repayment of capital at maturity.
• A 'floor' - fully protects a certain percentage of the investment, but the investor is exposed to any initial fall e.g. 80% of capital could be fully protected, but the investor will suffer the risk on the first 20% of the fall.
• Soft protection - this is also called a 'barrier', or a 'safety net'. This protects the investor from initial falls, but if it's broken during the term, the protection disappears. Investors then suffer a loss, unless the index has fully recovered at maturity.
• Hard protection - also called a barrier, but it's less common as it costs more to provide. A hard barrier also protects the investor from the initial fall and exposes them if the index breaks this safety net. It differs from a soft barrier, because it can't be broken during the term. It only matters whether the barrier has been broken at maturity.

Once you have worked out exactly what type of protection is being provided, make sure you go that one step further and double check how losses are calculated, if there is only partial protection in place. Normally there would be a 1% loss for every 1% fall in the market, but some structures have geared downside risk. If the market falls and capital protection disappears, the loss to investors could be greater than the fall in the market. For example, 2% or 3% losses, for every 1% fall.

As financial planners we need to have our eyes wide open. While these types of investments should reward investors with far greater upside potential, they're not for widows and orphans. And if the detail isn't correctly read, crucial risks like this can be missed.

b) How does the provider put capital protection in place?

In the vast majority of growth products, capital protection is put in place using a 'zero coupon bond'. This is just a bit of flash jargon which means that you invest a good proportion of the investor's money in a fixed term deposit. As interest accumulates over the term, you can then be certain that the deposit has grown back to the original amount and investors can be repaid. The remainder of the money is used to buy 'options' and create a structure which lets investors participate in sharemarket growth.

If this type of method isn't being used (i.e. the zero coupon bond, issued by a major highly rated financial institution with options on top), then there should be another explanation. If it seems clear that capital protection is being provided in a different way, then it's likely there are additional risks for investors.



2. Participation rate

The 'participation rate' is simply the percentage rise in the index which an investor is being offered. A product offering 70% of the rise in an index has a 70% participation rate.

With structured products, participation rates rise and fall, depending on market conditions (just like interest rates on a term deposit). It pays to have a rough idea what factors cause this pricing to move - that way you can be confident the product is still offering good value in current conditions. Here are some examples:

• Interest rates in NZ - rising rates will give increased participation in the upside of an index and falling rates have the opposite effect, giving less participation
• Differential between NZ interest rates and offshore - this is only relevant if you are using an index based outside of NZ and removing the currency risk from the investment. An increased differential gives more participation and vice versa
• Market volatility - rising volatility gives less participation. Conversely, more stable markets or falling volatility, allow more participation
• The term of the product - a longer term gives more participation in the upside and shorter term products offer less upside
• Capital security - less security, gives more participation and vice versa

Just to pick out one point as an example - the differential in interest rates. If you take the Nikkei index and bring it back into a New Zealand dollar product, you'll find there's a pretty enormous difference between Japanese and NZ interest rates. So when you hedge the investment, there's a big pick-up received. This should be used to give investors more participation in the index.

When you see products with the Nikkei index in them, you should be looking for that extra reward. Some providers will add in an index like the Nikkei, in order to ensure the product has a decent participation rate and to make it look more attractive. There's nothing wrong with the product at all, but as financial planners we need to be aware of why it's being used and the effect it should have on the terms of the product.

As you can imagine, the factors above, such as interest rates and volatility, can all begin moving in different directions and to different degrees, causing the participation rate to vary. If you're interested, but can't quite figure out why a new product is now offering different terms to the previous issue, just ask the provider to explain what's been going on in the market.

For financial planners it's important to always consider the product's participation rate in conjunction with its capital security to make sure you feel the trade-off between the two is a fair deal for the investor.



3. Growth cap

Some products put a growth cap in place - a maximum return which can be gained. Always ensure you know whether this feature is in a product and then weigh it up against both the security offered and the participation rate. There's no right or wrong formula to look for, you just need to be comfortable that the combination offers a fair deal.

4. Index or underlying asset

Structured products can be linked to just about any underlying asset, from an index, to individual shares, a managed fund, gold etc. But just because you can wrap capital protection around almost anything moving, doesn't automatically make every product appropriate for the retail investor. Overseas experience has shown that advisers prefer passive investments as the basis of these products and they can thrive as a core holding in a portfolio. More active and specialist investments can then be built around this.

When you look at any new product, the underlying asset might seem like the best feature to help you decide where it belongs in a portfolio. For example, if returns are linked to an international index - bingo - that belongs in international equities. But structured products tend to question traditional portfolio theory. So how do you classify them? If you look at the upside potential, it belongs in the international equity box. If you look at the downside risk though, it might be fully protected, so it doesn't belong there at all.

In short, trying to classify structured products in terms of existing theory, just means they end up being stuck in the wrong box. They have to sit in a category on their own and you have to weigh up their suitability for a client on a combination of both the upside and downside. Sticking them into the alternative asset class box is only a quick fix, but often an interim solution for structured products.

5. Term

The term of an investment becomes relevant for three main reasons:

A. The longer the term, the higher the participation rate should be. Why? Because when capital protection is created, a large proportion needs to be invested in the fixed term bond, to allow interest to accumulate and grow back to the original amount. The longer the term, the more time there is for interest to accumulate. That means less money needs investing in the bond and there's more left over to go and buy options with.

B. Shorter term investments are actually riskier. If the market does go down, there's less time remaining to recover any losses. If a product is only partially capital protected, this becomes quite relevant. With these types of products you need to be looking for a sensible combination of partial protection and length of term.

C. Watch out for products with a mysterious delay at maturity. It's a wee trick that providers can use to make the overall returns seem better and it's most commonly used on products providing an income. The term may be 5 years and an income rate declared, but the investment may not be repaid for a further 2 months. Always convert the income to a true annual rate of return if you discover this.

6. Averaging

When it comes to setting the start and end levels of an index, there are a number of options open to providers. It's fairly standard practice to set the level by taking the monthly average over 6-12 months. Final index averaging actually gives investor some valuable protection at the end of the term, if the market falls away. However, in a rising market averaging can limit the gains. The more averaging you add to the design of a product, the cheaper it is to buy options and it should feed through into a higher participation rate. While a little averaging is quite normal, watch out for products that over average the returns or even at the extreme, fully average the returns throughout the term. While a higher participation rate might look attractive, it's really just smoke and mirrors.



7. Index measure

Measuring the index at maturity sounds a pretty simple task - just use the closing level on the maturity date (or the monthly average as discussed earlier). But in other markets, a wee device called a 'look-back' has appeared. This involves setting the final level, by taking the lowest intra-day level over say the last 6 weeks of the investment. On an intra-day basis shares are fairly volatile and using this method will knock a bit of the head off the returns at maturity. If all other aspects of the product look strong, this measure may not be of huge concern, but it's certainly one to watch out for. The lesson is to always find out how the index is measured.



8. Charges

The great thing about structured products is that the returns and risks are very clear and transparent and no annual management fees should be paid by the client. The issuer's margin is priced into the product at the beginning and the terms offered to the client account for that margin. An adviser's brokerage can also be priced into the terms of the product, so when a client invests, there are no external charges to pay. This is very common in areas such as the UK, where an entry fee is rarely seen. In NZ there's currently a combination of both, but advisers who charge for their service can rebate any entry fee.

Any provider charging an annual management fee should be attracting scrutiny - it certainly isn't international practice and can really only be viewed as a cheeky way to gain more margin from an unsuspecting investor. Once a product is structured, it becomes a passive investment, there is very little to do (mainly compliance). Charging investors for doing very little, is pretty bad form.



9. Tax efficiency & 10. Wrapper

Structured products the world over seek to be tax efficient so the wrapper you see around a product is usually there to ensure tax is kept to a minimum. In the UK, Dublin and Guernsey based companies are the norm. Vast volumes of products are also sold in bank and building society accounts, because investors don't like stepping out of their comfort zone.

The saying goes "don't let the tax tail wag the investment dog" and it stands true in the structured products market too. Tax efficiency is a 'nice to have', but always make sure you are comfortable with the actual structure of the product first.

When comparing products, always reduce the returns to a net basis. If the product is not tax efficient, there will be a good dent in the returns. For example, you may be offered 80% of the upside of an index, but if you have to pay 33% tax, the participation rate is effectively around 50%. The same goes when you compare these products to ordinary passive or active funds. These funds may offer 100% of the rise in the shares they invest in (with no protection), but if they are not tax efficient, their participation rate effectively reduces to 70%, and a tax efficient protected product could actually outperform.

Two other factors which need to be accounted for in the New Zealand market are:

a. How the wrapper affects the timing of tax payments. If tax has to be funded annually over long periods in advance, there is a funding cost which needs calculating. Tax is being paid which could have otherwise been invested elsewhere. Feeding this into the calculation will significantly reduce the returns on an investment, but this needs to be done to make accurate comparisons.

b. The Foreign Investment Fund (FIF) rules only allow a very small exemption for natural persons of $50,000. Many investors don't seem to realise this is across all their FIF investments and if they exceed the threshold they are liable for tax on an accrual basis (i.e. before returns are actually received)