Time for financial advisers to embrace structured products?

Neither financial advisers nor investors have been particularly interested in structured products over the past few years and the sector has significantly shrunk since the global financial crisis. However, the capital protection feature seems to have quite a lot of appeal, writes Janine Mace.

Times are changing. With the share market rollercoaster continuing to deliver clients a wild ride, financial advisers are increasingly facing up to the idea they may need to find a fresh path through the volatile new investment environment if they are to deliver the growth and capital protection clients want.

Many are realising they are stuck on the horns of a dilemma – choose to play it safe until markets settle down, or accept things have changed and new strategies and tools are needed.

To do that, financial advisers may need to get over their longstanding hesitancy over embracing the complexity of structured products.

As Geoff Watkins, managing director of specialist consulting firm Path Independent, explains: “A typical adviser view of structured products is they are too complicated and they feel frustrated at the costs and lack of transparency.”

He believes they need to overcome this view if they want to access the product solutions available to protect client investments.

“Many advisers are critical and disinterested due to transparency concerns, but on the flipside, they are very interested in capital protection for clients. They want the protection, but this is hard to achieve without complexity,” Watkins argues.

Standard & Poor’s director fund services Rodney Lay agrees complexity is an issue with structured products, but he believes it can be overcome.

“Structured products are generally not that complicated, but you need to understand them. Knowing your product is essential in this area,” he says.

Watkins believes the share market declines in the second half of the year may have been the final straw. “In the past two months, people have been very interested to talk to us – much more than in the previous six months,” he says.

“Before that many financial planners seemed to be hoping there will be a return to business as usual, but the turmoil of August and September has seen some advisers decide they may need to start doing things differently. There is a shift in thinking by advisers to consider alternative investment tools, as they realise the old model may not be coming back.”

Slow market growth

Despite this new willingness to at least consider structured investments, the market still has some way to go. 

The March 2011 Investment Trends Capital Protected Products Report found in December 2010 there were only 50,000 investors in structured products, which represented a modest rise from the 43,500 in November 2008.

The figures highlight the slow growth in the structured product market at the moment, according to Lay. “It is not a particularly vibrant market in Australia since the global financial crisis (GFC). We have seen less resources being thrown at the sector since then.”

This explains media reports that major investment banks such as Bank of America, Merrill Lynch, RBS and UBS have experienced recent staff departures due to the reduced retail sales volumes in structured product since the GFC.

Watkins agrees interest is limited at the moment. “Actually there has been very little money going into structured products – or most investment products except term deposits – in the past six to 12 months,” he says. 

“As far as flows go, there has been very little and in terms of size, the structured product market is irrelevant compared to the rest of the investment market.”

Lay believes the outlook will remain unchanged for some time. “Most people expect to see the market stay flat, as there is a very high degree of risk aversion at the moment. Financial advisers are reluctant to put money into structured products in such a risk-averse environment.”

Who is interested?

Although there is limited information about Australian investors in structured products, what is available indicates investors have several main areas of interest.

A recent paper by the Australian Securities and Investments Commission’s chief economist, Alex Erskine, for the 2011 Australian Centre for Financial Studies’ Money and Finance Conference, gathered together some of the available data from the Investment Trends survey to create a portrait of structured product investors.

Erskine noted their median age was 56, they had a median income of $110,000 and a portfolio size of $1.2 million. Most (60 per cent) were investing in their own name, with 32 per cent investing through self-managed super funds (SMSFs).

The key factors triggering their initial investment were diversification (43 per cent) and capital guarantee (43 per cent). Internal gearing was being used by 15 per cent of investors, while 17 per cent had gearing by the product provider.

This data matches the experience of those working in the area, with capital protection products representing the major growth area in structured products.

As HSBC head of sales in global markets, Ian Collins, explains: “Products which maintain 100 per cent capital protection have seen a good pickup in interest from real investors, rather than investors interested in short-term products and trends.”

These real investors increasingly include SMSFs. “We are seeing more interest by SMSF investors as the five-year timeframe suits their investment horizon,” he says.

Capital protection is the major attraction for the smaller balance investor. “The main focus on the 100 per cent capital protection is in the retail market, but less so at the wholesale level,” Watkins notes.

“We have been promoting bespoke products for wholesale investors and we have seen further interest in this area. The move in that space is away from full capital protection to shorter duration products.”

Capital protection was an important component in the SMSF structured products launched earlier this year by Deutsche Bank and Wilson HTM. These products were designed to provide upside to the S&P/ASX200 and offered the choice of two strategies – 100 per cent principal protected or 85 per cent protected.

According to Wilson HTM, the product was designed for SMSF investors who were keen to have a leverage exposure to the share market without the risk of margin calls.

Collins believes there are two areas of interest when it comes to structured products. “The interest is in short-dated structured products with no capital protection, or in long-dated products with full protection.”

The Erskine research paper also highlights the importance of diversification when it comes to structured products. According to Collins, this attribute is now more important to many investors than the gearing element that largely drove structured product use pre-GFC.

He believes structured products can be used to provide diversification and assist with easy access into unfamiliar or inaccessible asset classes.

“Where we see structured products as fitting into the portfolio is for investors with a long time horizon and who are seeking capital protection as a safe way to access an asset class that they may not be that familiar with, such as emerging markets or global equities,” Collins explains.

There is also interest in other areas. “We are seeing a pickup in demand in the dual currency investment space and also in reverse convertibles due to current market conditions,” he says.

Leverage loses popularity

With only a small group of structured product investors involved in gearing, this represents a major change from a few years ago.

“The big products pre-GFC were the loan products and those are now mostly no longer around,” Lay notes. 

Much of this is due to the fallout from the use of constant proportion portfolio insurance (CPPI) in structured products issued prior to the crisis. The cash-lock that occurred with many of these older products has led to the emergence of new volatility-targeted products.

“Most loan products aren’t in the market anymore as the environment is not as attractive as it was due to changes in the interest regime and equity market conditions,” Lay explains.

“Structures that providers were using such as CPPI are not being used any more.”

While leverage products are less popular, they have not disappeared entirely.

According to Lay, some of the newer leverage products have the entire investment at risk and include a form of call option. The idea behind them is to put a small (1 per cent – 2 per cent) part of the portfolio into the product to achieve a much higher market exposure – often around 10 per cent.

“These are very high risk products and the market needs to go up by a certain percentage to achieve a return,” he notes.

Watkins agrees leverage products have reduced appeal. “There has been some interest in the Macquarie Flexi Trust-style geared and protected products, but they are June-type products,” he says.

“The few products in the market are ticking along, but there is little hope of it getting back broad market interest for some time.”

The growing use of structured products by SMSFs is also making the tax aspect less important, as this investor group is less focussed on tax, Watkins notes.

Simple is best

One of the main changes in the structured product market has been driven by financial adviser and client feedback for simpler, more understandable products.

According to Collins, there is far less interest by investors in ‘black box’ or complex products than in the past. “This view has been reinforced by the fact that complicated structures didn’t perform as well in bear market conditions.”

Lay agrees: “There has been a change to make them a little more palatable over the past two to three years.”

While newer structured products still consist of underlying assets and an additional structure over the top, there have been big changes made to the underlyings.

“The underlying assets have been simplified since the GFC and now mainly offer a basket of equities or index exposure such as the ASX200 or S&P500 in the US and also basic exchange traded funds. They have been really simplified,” Lay explains.

“The issuers are trying to make them as simple as they can so advisers will be interested and understand them.”

There has also been a strong trend towards shorter duration products. In the past, structured products tended to run for five-plus years, but most now have a duration of around three years.

“We have seen a move towards shorter tenor or duration products. These tend to be riskier, but also offer a yield pickup,” Collins says.

While innovation in the structured product space is limited at the moment, there are tailored products being developed.

“There is some bespoke product development being undertaken for some dealer groups, but these are small $20 million issues for a specific dealer group’s client needs,” Lay says.

Watkins agrees: “There are bits and pieces going on and some tailored products being developed. Some are likely to hit the market very soon for specific dealer groups.”

However, when it comes to a wider rollout of these products, Watkins is uncertain. “The question is: will many funds and fund managers come out with them and will they have the resources to put behind them? There are difficulties in how to communicate them to clients and there are a lot of challenges in developing broad market appeal.”

The current heightened regulatory concern about structured products is also likely to see some manufacturers pause.

Protection for retirement savings

One of the key areas where the popularity of structured products will grow is in providing protection for retirement savings.

Structured products designed for this purpose such as OnePath’s MoneyForLife, Challenger’s Liquid Lifetime and Macquarie’s Lifetime Income Guarantee have already found a niche. 

Lay believes there is a demand for retirement-linked products that provide “income certainty and increasing retirement income over time”. 

However, they have yet to achieve a significant market. “The retirement products are useful, but the uptake has been less than expected by the issuers, except for AXA North. North’s popularity is due to the better protection it provides than CPPI, but the price is the cost of the capital protection. AXA North shows investors still want capital protection, especially in the pre-retirement phase,” Lay says.

With a rapidly ageing population, more capital-protected products are expected to emerge.

“There is a lot of work being done in the background on developing products delivering capital protection attached to the platform or super fund where the investor holds their assets,” Watkins notes.

“Australians are not really keen on long-term income stream products, but they are looking at capital protection in the pre-retiree and retirement areas. Interest seems to be about finding solutions for retirement income strategies, rather than income streams,” he explains.

Solving client problems

Despite the flat market, structured product experts remain convinced they have an important role to play.

“Structured products do certain things and have specific profiles for specific investor groups. They appeal to certain investors and to investors at certain points in their investment lifecycle,” Lay explains.

Collins agrees they can be very valuable in solving particular portfolio problems. “They can provide investors with access to income as well as capital growth. We are now structuring products that allow investors to take capital gains and income returns as well along the way.”

According to Watkins, the key to successfully using structured vehicles is seeing them as a solution for achieving a client’s objective, rather than as a product. He believes much of the early product development was manufacturer driven, rather than client focussed. 

“There are benefits from structured products as long as things are clearly explained and they serve a useful strategy purpose. Whatever the product, it shouldn’t be the driver, the strategy should be. Advisers need to work out the strategy they need and then find a product that suits that or meets that need,” Watkins notes.

In particular he believes structured products can be used to solve the tricky problems around poor investment market growth and capital protection. 

“Structured products address them by increasing returns, locking in gains in both rising and falling markets, and by limiting downside losses,” Watkins explains.

To successfully use structured products, Lay says financial advisers need to understand the structure, payoff profile and performance of the vehicle in different market conditions. “They also need to match the product to the right client,” he notes.

Collins agrees: “There is definitely a future for structured products, but you need to pick the right product for the right circumstances.”

Both Collins and Watkins believe the Future of Financial Advice (FOFA) reforms will have an impact on the structured product market. 

“The future use of structured products is going to be a function of FOFA and how financial planners approach their business,” Collins says.

“Advisers are maintaining the view that there is a role for them in a portfolio, but they are not sure yet how their remuneration model will fit in a post FOFA world.”