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Nick Sketch slams expensive and overly complex structured products

Nick Sketch slams expensive and overly complex structured products

Nick Sketch, senior investment director at Investec Wealth & Investment (pictured below), explains how investors can gain access to Europe with downside protection, and play UK dividends through structured products. 

What are some of the most interesting products you have seen recently?

Over the past few months I have seen lots of new FTSE autocalls issued, and these have been needed to replace existing products that have been repaid. However, equities are higher, credit spreads are narrower and volatility is right down. This means prospective returns are a lot lower than they were a year or two ago.

Some investors have responded by keeping their return targets up and increasing risk tolerance. This is sometimes done by raising the final barriers, or by using a less robust credit or by basing returns on the ‘worst of’ two indices.

What are some of the risks involved?

Apart from anything else, ‘worst of’ structured products effectively mean that investors are selling volatility and buying the correlation between the two indices.

Although terms for the latter have improved recently in some areas as correlation has fallen a little, investors are generally still not getting great value for taking a bit more risk.

Value for money plus risk awareness means other investors are casting the net more widely. Rather than replacing a lower risk holding with a new autocall, some are opting to move that money away from structured products for now.

Instead, it can make more sense to use your structured products allocation to replace part of a portfolio’s equity exposure by buying a participation product.

Taking HSBC as a high quality example, you can buy a structured product today with soft protection in six years 40% below today’s market level, which also offers 200% of the capital increase in the S&P 500 index.

Based in US dollars, this is a credible alternative to a US equity fund or exchange traded fund (ETF).

If, instead, you are more interested in Europe, you can get -40% downside protection for the sterling price, which could prove to be very useful if Europe disappoints us again, combined with 260% exposure to gains in the Eurostoxx index, and without direct exposure to the euro.

Are there any products that are particularly attractive at the moment?

One interesting structured product available today is effectively a tracker fund based on FTSE dividends. Dividends are a good deal less likely to dive dramatically than share prices and will benefit from any future sterling weakness, yet returns of 5%-9% a year are a reasonable hope from simply buying the dividends the FTSE will pay in 2015.

This not only turns taxable income into capital gain in an uncontentious way, but also offers a comparatively defensive investment based on the FTSE that should produce a decent return even if the index falls a little in capital terms in the next couple of years.

In today’s environment, that might not be a bad replacement for a traditional autocall.

What issues do you have with the ETF and structured products industry?

Too many structured products have a fairly high chance of delivering a much duller outcome than was hoped, even if nothing actually goes wrong.

For example, anyone who bought a structured product that accrued gains as long as the FTSE 100 stayed within a set range might find themselves today hoping that the index doesn’t rise in the next few years.

This is particularly true if the top end of the FTSE range used was only (say) 6,500 or even 7,000.

More serious perhaps are the perennial issues of over-complex products and products that represent bad value compared to simpler ways of doing the same job.

The desire to keep structured products simple also reflects sentiment that complex products can be harder to manage as holdings in a diversified portfolio. They can be bought to do one job but develop changing sensitivities and hence behaviour as prices move, which needs careful supervision.

Moreover, more complex structured products are usually more expensive structured products.

Of course, all that leaves some investors looking for new investments likely to deliver 6%-10% a year if things go fairly well and without being too closely connected to the short-term vagaries of stock markets.

Some structured products look less appealing in this area, but they are not the only choice.

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