You can manage risk, but not returns

There is a groundswell in global activity by financial institutions and financial product issuers attempting to engineer, design and manufacture investment products that provide institutional and retail investors access or exposure to equity markets while maintaining an acceptable level of risk. These products are commonly known as ‘structured products’.

It is important to understand the impact of this momentum and how it will impact the financial advisory business in Australia. In order to have an insight into this, we must first define our understanding of risk in relation to structured products. We define risk as the likelihood of the investor being exposed to factors that may lead to a loss of capital or the creation of an opportunity cost within a defined time frame.

With a substantial increase in the quantum of structured products being introduced into the Australian market, research analysts have a challenging task — the differentiation between alternative assets and alternative structures.

Structured products are often categorised as alternative assets. However, while the structure may be significantly different to the traditional long-only unit trust structure, the underlying asset class or investment exposure may in fact be exactly the same. The point here is that asset allocators often allocate structured products to an alternative sector as opposed to the sector represented by the underlying asset classes — for example, Australian equities or international equities.

The return from, say, a long-only international equities unit trust will be determined by the individual stock portfolio performance and the capacity of the discretionary manager to add value. However, the return from a structured product, which provides exposure to a similar portfolio of international securities, will be determined by the stock performance, mechanics of the structure, and often non-discretionary selection criteria.

Given that the discretionary component of a traditional managed equity trust is rewarded through performance fees, the net value-add to the investor is often questionable. It should be noted that there are structured products that provide exposure to alternative asset classes.

As with traditional managed unit trust products, there is now increasing price pressure on issuers to deliver more cost efficient structured products to the market. For many structured products, the discretionary component of investment selection is removed and we therefore see a stronger correlation between fees and returns than in discretionary-style equity funds.

While a structured product will not typically produce a management expense ratio (MER), we believe these types of products will display a similar pricing structure to that seen in wholesale funds currently available in Australia.

Structured products by nature are engineered to provide a specific outcome. As a result, the objective of many of these products is to provide investors with an absolute return on funds invested. The days of promoting out-performance against an index have gone. Structured products effectively mean you can manage risk, but not returns. The underlying structure manages risk while the asset class determines returns.

Proponents of traditional portfolio theory will argue that many structured products that provide a capital guarantee expose the investor to a potential opportunity cost in the event that the underlying asset class does not perform in the short-term. Structured products that utilise threshold management will often rely on a leverage exposure for the equity remaining after the guarantee has been funded. As a result, a significant negative movement in the underlying asset may trigger a threshold breach, leaving the investor with the net present value of the guaranteed amount.

For many investors, this opportunity cost is an unacceptable level of risk. We are now seeing products that provide utility to the investor in this situation whereby they are given the opportunity to exit the structured product in the event of a significant negative movement in the underlying asset. In addressing this opportunity cost issue, these products further reduce risk to the investor.

The exposure methodology for a structured product is an important component in determining the efficiency of the product. This is driven to a large extent by macro-economic factors at the time the structured product is released, as many have determined timeframes.

For example, the global interest rate environment will usually directly impact the level of underlying investment exposure for a product that has a defined term capital guarantee. Given Australia has relatively high interest rates, current levels of underlying exposure for this type of product remains high.

Second, if one considers that volatilities on global equity markets are at historically low levels, options may be a more cost-effective exposure mechanism than, say, a leveraged threshold management structure.

While traditional asset classes remain unchanged, the drivers behind the development of new structures, which provide enhanced risk management and greater investor utility, are significantly bigger than the Australian investment management industry. The global growth in computer and information technology provides a powerful springboard for the development of new products. These products will change the financial services industry in Australia.

Ross Benson is chief executive of Capital Guaranteed Investments.