Many financial advisers are avoiding structured products in a bid to maintain simplicity, transparency and liquidity in their clients' portfolios.
It’s a refrain that can be heard across investment markets: investors want simplicity, transparency and liquidity.
And despite the reputation of structured products for complexity, this clarion call is being heeded by structured product issuers in a bid to turn around adviser and investor sentiment, which has remained poor since the global financial crisis (GFC).
On the nose?
Many advisers are still shying away from structured products on the basis of a focus on maintaining liquidity, and only including products in the portfolio that a client can readily understand.
Prior to the GFC, investors were willing to take a much more speculative perspective on structured products, but the days of ‘taking a punt’ with some spare money are over.
The legacy of the credit crisis, particularly for those who were involved with products which cash-locked as a result, has “left a very bad taste in the mouth of a lot of investors, and advisers who had to manage their clients through that process”, according to Lonsec senior investment analyst Stewart Gault.
This has resulted in the retail structured products market being much harder hit than the wholesale market.
Dr Tony Rumble, founder and CEO of Alpha Structured Investments, believes that there is still a high level of adviser and investor scepticism about structured products, and the lack of enthusiasm is in large part a combination of the post-GFC fallout for anything complex, compounded by a lack of momentum in the equity market.
“I think the pretty poor inflows into structured products would be in line with the weak inflows into investment products generally,” Rumble says.
Gault agrees that the limited and declining level of interest in structured products over the last few years has been partly driven by the market environment.
“It would be very challenging for issuers to convince investors to move out of cash and borrow some money and invest in something when markets are not showing long-term positive signals,” Gault says.
Claire Mackay, director and wealth advisor, Quantum Financial Services, brings a unique perspective on structured products, having worked for several years for an issuer, creating hybrids and other structured investments.
She says when analysing structured products, this has sharpened her focus on what’s in it for the client, as well as the issuer.
“From the perspective of a client, I’m always looking for the catch. You have to really understand the products, and how they are going to behave in market upswings and downswings,” Mackay says.
She points to the capital-protected and Constant Proportion Portfolio Insurance (CPPI) products as examples of those which might be suitable when markets are falling, but not when a recovery is in progress.
A thorough knowledge of how the investment will work in all market circumstances, its benefits, and perhaps more importantly, its limitations, and the costs, are therefore essential.
“In volatile times, there are some products that are designed to address volatility, but you need to look at the fees you are paying for that and whether it is really going to behave how you want it to behave,” Mackay says.
And while advisers, if they have done their homework, might be clear on these attributes, clients also have to be confident, and many simply don’t understand some of the more highly engineered products.
“Many new clients who have come to us with some of these investments just want a simple portfolio. In an uncertain world, simplicity, liquidity and accessibility are valuable attributes,” Mackay says.
A role to play?
Some advisers are still, of course, playing in the structured products space.
Not the domain of the ‘plain vanilla’, mass retail market, more interest has perhaps always come from those with a more sophisticated, high net worth client base, who have made offering more complex products part of their value proposition and compliance framework.
“The advisers who are still recommending structured products to clients are those that have actually spent the time to really understand the products, whereas others are probably less involved now,” Gault says.
As market interest has cooled, there has also been a shift in how advisers might use structured products in the portfolio, according to Instreet managing director George Lucas.
“Pre-GFC, advisers usually used structured products mainly for tax-effective purposes, but now they’re using them as portfolio construction tools,” Lucas says, adding that the growth of self-managed superannuation funds has also given this trend impetus.
In addition, investors whose portfolios are dominated by direct property are using structured products to diversify.
Geoff Watkins, managing director of specialist investment consulting firm Path Independent, believes investors and advisers should be looking to structured products to capitalise on some of these opportunities.
“More clients and advisers should realise that you can use structured products, rather than the stock-standard assets, not just to have black and white outcomes, but to set up better portfolios. But we’re not there yet, and in retail, those attitudes move quite slowly,” he says.
While there has certainly been a contraction in the number of issuers and the number of products coming to market over the last five years, Watkins says there has been an uptick in inflows over the last six months, for a couple of reasons.
“There is too much money currently sitting in cash or very low-yield assets, and as the cash rate is going down, the stockmarket is picking up, so people are looking for exposure. So the past six months have seen more money flowing into some of the product than there was in the last few years,” Watkins says.
The influx of money may also be a function of product issuers reacting to investor scepticism by creating easier-to-understand products, Rumble says, utilising simple and robust innovations – such as basic instalment products, and limited recourse finance for share and property buying in and outside of SMSFs.
“Structured product issuers have become more cognisant of SMSFs as potential clients. So it’s very uncommon now to see a product with a loan attached which is not a limited recourse loan, structured for super funds,” Gault says.
Instreet is one of the issuers that has been quite active in the market this year, with a focus on releasing products designed to act as portfolio construction tools. While Lucas says they have seen a 5-10 per cent drop in inflows this year, its new YIELD product has gained traction quickly with advisers.
“We still see a demand for yield products and capital protection, and there’s still a constant flow of alternatives as well,” Lucas says.
“There’s been a little shift in adviser sentiment to try to find products that will provide a more consistent return, which is why alternatives are attractive.”
Most popular structured products
Given the focus on simplicity, it should come as no surprise that relatively simple products, such as structured products overlaying an index or basket of stocks, are finding more investors than those structured over hedge funds and fund-of-funds – because clients understand the underlying assets better.
“There is always going to be some complexity around the structure, but if you can keep the underlying simple, then overall it makes it simpler,” Gault says.
“There are still some very exotic and complex products that have the latest and greatest financial engineering embedded within them, but I think from the perspective of an adviser it’s not really something that they’re willing to bother with, because they’re not sure of what’s under the bonnet, it’s difficult to explain to the client, and they’re also concerned about PI cover,” he says.
In Rumble’s view, instalment warrants and protected loan products are amongst those gaining the most traction in the market at present, driven by two categories of investors: an investor who has a particular view of a stock and wants to capture that as the market rises through a protected loan or instalment, and self-managed superannuation funds which are using some of the new styles of protected loans and instalments to diversify and gain exposure for a lower cost.
“If you put an instalment structure over a stock like Telstra, you might be gaining yields of about 20 per cent per annum, so I think we will definitely see a continuation for the next one-to-two years of income-enhancing through gearing,” Rumble says.
“As the share market shows more green shoots, you’re going to see more opportunistic investment with that 50 per cent instalment structure.”
Though many advisers and clients don’t consider hybrids as falling into the structured product “basket”, technically they do, Watkins says, and “that particular niche has been booming”.
Despite the lack of appetite for exotic structured products, he adds, “some of the actual structures moving in those hybrids are a little bit more complex or new, so they come in at times and in ways you wouldn’t expect. If they were called structured products, those types of more exotic deals would tend not to get sold”.
And while some providers have been heavily promoting capital protection products, tapping into investor fears about losing their capital in the ongoing market volatility, Mackay sounds a warning on these products.
“We go back to the client’s attitude to risk. My view is that if you’re trying to reduce your risk by going into a product that’s capital protected, is the risk and what you’re prepared to pay for the protection, worth it in the first place?”
Some of the innovations to structured products have been specifically designed to address perceived shortcomings.
While the number of overall products being issued is down in the last 12 months, the new product space has been dominated by issuers setting up structures where they can effectively roll out slightly tweaked versions of a product each quarter, such as Macquarie Flexi and Instreet Mast and Link, according to Gault.
“Because the pricing of structured products is dependent on the level and volatility of the market, interest rates and all the factors that affect derivative prices, the ability for issuers to be able to release products quarter by quarter allows advisers the time to speak with their clients and get them comfortable with the product,” he says.
“They’re not forced into an annual window where they had to commit in the next two weeks, which was what it was like in the past. I think it gives advisers better certainty about the structure, it doesn’t change very much, and they can plan their meetings with their clients around that timetable, which is more convenient.”
To combat issues with cash-locking, issuers are also building “walkaway” features into new products. These allow an investor, when paying interest on loans at certain periods, to simply choose not to make the next interest payment and walk away from participation in the product.
In addition, issuers are shortening the term for structured products.
“Pre-GFC, products that could go out to five-to-10 years were not uncommon, whereas today it’s very hard to find a five-year product. Most products tend to be within the one-to-three year tenor,” Gault says.
“The shorter tenor and the ability to not be locked into a product for the remaining term are certainly better responses to client requests.”
Reflecting the growth in popularity of exchange-traded funds (ETFs), Lucas says his company has observed much more demand for products using a deferred purchase agreement (DPA) structure as a tax-effective and cost-efficient way to access direct equity, particularly for offshore markets.
“One trend we’re seeing is the growing use of DPA structured product as a way of delivering ETFs into Australia,” Lucas says.
FOFA: death knell or blessing in disguise?
Structured products issuers not only have scepticism and market challenges to contend with when it comes to getting their products in front of investors.
The impending implementation of the Future of Financial Advice (FOFA) reforms, and the ban on conflicted remuneration is expected to deal the traditionally commission-driven structured products market a further blow.
The difficulty in explaining a structured product has meant that advisers have typically offered them as a stand-alone product as part of a targeted campaign, but this type of commission-based offering will no longer be possible, contributing to the market’s decline, according to Rumble.
“Because of the pressure that FOFA produces on their fees generally, a lot of advisers are actually looking to simplify their business offering. The idea of campaigning a structured product as a special offering is now much less attractive,” he says.
“So maybe the more sophisticated advisers will continue to do that, and maybe they’ve got a fee structure that’s slightly more appropriate.”
Some argue that FOFA will be a good thing for the market, in removing ambiguity and providing greater clarity about the fees and rebates associated with structured products.
Lucas says that because about half the advisers using his company’s product are already rebating fees, Instreet does not expect to see a significant impact.
The lack of ability to pay commissions might also drive issuers to more comprehensively educate advisers on the features and attributes of structured products, so they are in a better position to recommend them to clients with confidence, according to Damien Richard, partner at King and Wood Mallesons specialising in managed investments and structured products.
Richard believes that FOFA is starting to have a material impact on the structured product market, though the market conditions have had a greater impact, with fewer and simpler products being offered, “so advisers and clients are better able to understand the products, and they’re easier to disclose in offer documents”.
In Watkins’ view, those advisers who are interested in structured products now are not driven by commissions, but by wanting something different to offer their clients.
“There is a group of advisers across the spectrum who are moving more into high service, high net worth, more sophisticated advice.
"They are very deliberately wanting to prove why they are different to the rest of the advisers out there by offering their clients more tailored strategies and products for a particular need these higher-end clients have,” he says.
“They are the people who will continue or expand their use of structured products.”
Regulation: spotlight on disclosure
In recent years, the market has been largely free of uncertainty about how the regulator and the Australian Taxation Office (ATO) will treat certain aspects of structured products. Instead, since the GFC, there has been “incremental regulation” of structured products, particularly around adequacy of disclosure, according to Richard.
“The philosophy of our regulatory regime is not to prohibit certain kinds of products, unlike some offshore regimes, but to increase transparency and disclosure so that consumers understand exactly what they’re buying, in terms of the features of the product and the risks involved,” Richard says.
This has translated to selective targeting of particular products such as hedge funds, contracts for difference (CFDs), exchange-traded funds, and other structured products.
“We’re seeing that through the Australian Securities and Investments Commission (ASIC) giving guidance in relation to product disclosure statements, and also how these products are advertised to make sure that investors are presented with a balanced picture of the products,” Richard says.
“So that is a clear challenge for structured product issuers on the disclosure side, and that is key to success in our market, both from a regulatory point of view and also increasing investor confidence in the products.”
ASIC has also introduced its short product disclosure statement (PDS) regime in 2012, and while it was intended to simplify disclosure for simple managed investment schemes, because of the parameters chosen, some structured products have been captured by this regime as well.
“There have been some issues around whether the short PDS regime is suitable for more complex [structured] products, and as a result of that, we’ve seen ASIC issue a class order to exclude hedge funds from the shorter PDS regime,” Richard says.
From a taxation perspective, the ATO has also been taking action on claims made by product promoters about the potential tax-effectiveness of certain types of structured product investments.
Most recently, in May this year, the ATO announced a crackdown on issuers offering sophisticated financial products claiming to offer franking credits and other tax benefits.
Tax Commissioner Michael D’Ascenzo said these products offered exposure to a portfolio of listed securities using a derivative instrument to direct the cash dividend to a counterparty, while attempting to retain the benefits of franking credits on the dividends.
There were concerns these arrangements might not comply with tax law designed to counter practices which undermined the imputation system.
“The arrangements are currently being dealt with by a new ATO taskforce on retail and wholesale financial products that promise tax or superannuation benefits that may not be available under the law,” D’Ascenzo said.
“The Taskforce is currently contacting the entities that are marketing and facilitating these arrangements about our concerns, including that they may risk contravening the promoter penalty laws.”
The type of consultative approach with the industry demonstrated by both ASIC and the ATO in recent times has been quite successful, according to Gault.
“I think the issuers that are still in the market are prepared to work with the regulators and understand that the market does need to be regulated, and that it’s a good thing for clients.
"Issuers shouldn’t be out there trying to sell a product based on false claims. I think people in the industry who are following the rules support strong regulation in that area to stamp out the cowboys.”
Improving the state of play
To improve the success of structured products and ensure the perils of the past can be avoided, financial advisers who do utilise these products need to have greater clarity about what they are recommending and the strategy behind it.
“The basis of the advice and why you are putting this person in this product needs to be very clear,” Watkins says.
And according to Gault, that means issuers, research houses, advisers and investors must all take a more active role.
“It really requires everyone in the chain to do the homework that they need to do. As research houses, we need to work with advisers so at the end of the day, the right clients get into the products, because it’s when the wrong ones end up there that issues arise.”