AFR: Structured products – has anything changed?

Smart Money, Australian Financial Review, September 2010

In a financial services industry as developed as Australia’s, it should be little surprise that many groups have found opportunity in the financial crisis. A series of products have appeared that seek to help people get out of cash-locked structured products and regain them exposure to the markets.

If you don’t know what we mean by “cash-locked products”, then you’re one of the lucky ones. There are plenty of people who know all too well what it means and have been pondering what to do about it. Throughout the last decade, many banks and other financial groups have marketed structured products with capital protection to an increasingly enthusiastic investor base. These products offered the promise of exposure to various different assets – a stock index, perhaps, or the price of commodities – with the guarantee that provided you held the product to maturity, your money would be protected.

The problem was that many of the capital guarantees involved a system in which, in certain circumstances, the money you had invested would stop being exposed to the stock market (or whatever that particular investment was geared to) and would instead be put into cash or a bond that makes no return. This happened widely through the financial crisis when stock markets around the world nosedived. And, having been put into cash, there is no way back: they will stay so invested until the products mature. This is being cash-locked.

Two further problems are that it might take as long as seven years for those products to mature, though five is more typical; and that in most cases the investor in the product was encouraged, or very often required, to do so with a loan, on which they continue to pay interest today. So here they are: paying interest on an investment that has them sitting in cash just so that, in a few years time, they will get back exactly the same amount they put in in the first place, minus that interest bill, and having missed out on the stock market rebound in the meantime. “A lot of people are cash-locked, paying interest rates on products that won’t have any capital gain,” says George Lucas of Instreet Investment, which structures products that are then sold by banks.

There’s nothing illegal in this: these products did what they said they would in the circumstances. “The important thing to note is the products did exactly what they were designed to do,” says Peter van der Westhuyzen, executive director at Macquarie Bank. “I totally understand that being completely invested in cash with two or three years to go is not an ideal position to be in, but that was one of the possible outcomes that could happen if the market fell – and it did fall.”

Seeing how frequently this had happened, some banks have seen an opportunity and have launched products to get people out of their cash-locked investments and start them working afresh. One such is RBS. “There’s no silver bullet for that situation,” says Aaron Stambulich, head of public distribution for Asia Pacific. “But we can give people a chance to get some potential for growth.” RBS built a product called the Re-Strike Deferred Purchase Agreements through which investors in cash-locked products can bail out of them, surrendering their capital guarantee, and use what’s left of their money (probably about 80% of it in this environment) to get market exposure again in an RBS product underpinned by a new capital guarantee from National Australia Bank, without having to provide any additional cash. “It’s too early to say if it will perform, but it will give an opportunity to get some profit going forward,” Stambulich says.

These don’t work by using your existing investment as collateral; instead, they encourage you to cash out of an existing moribund product – which you can generally do, at a loss, at quarterly redemption windows – and put your money into a new product.

Other banks have tried this approach with limited success, for perhaps obvious reasons. “They’re not the most popular things in the world,” says Lucas. “One reason is that you open old wounds. Although these products have done exactly what they said they would do, if you’re now going back to the client and reminding them about the pain they’re going through, just to get them to go into another product…” Nevertheless Lucas has structured such a product for Merrill Lynch customers, using an existing product to swap clients into a new Bank of America note in order to regain exposure to the market, in return for an up-front payment.

Van der Westhuyzen says Macquarie offered some “variation options” for investors in its Fusion and Reflexion series – both of which have in many cases been cash-locked – “to help them gain new exposure to equity markets, and this was well received.” But he adds: “The bottom line is there is no free lunch in repaying shortfalls and there will be the usual set of cost/benefit tradeoffs.” Macquarie did not offer a similar variation this year, sensing lack of demand. Another group that has offered so-called rescue products is Perpetual.

Stambulich thinks RBS has an easier ride having not launched the unsuccessful products in the first place. “Every bank that sold the problem products has tried to do restructure trades,” he says. “The issue they found was that when they went back to their client base after putting them into something that turned into a nightmare, there was a lot of pushback. ‘I sold you this rubbish, here’s another piece of rubbish’. We’ve been a little more successful because we didn’t sell any of this before.”

But some are suspicious both of the RBS product and ‘rescue’ products generally. “The problem with these Restrike-style products is by the time investors have repaid the shortfall on the loan against the cash-locked product to close it out, then paid the fees and charges on the new product, there’s so little going into the underlying risky asset that the prospect of the investor getting anything for their time and energy is remote,” says Tony Rumble, founder of Alpha Structured Investments, which also develops structured products.

“I’m not only questioning the structure of the product but the need for it,” he adds. “I don’t think a lot of investors are running around demanding relief from cash-locked products.” In his view, the right time to do this was 12 months ago, when the equity market was commencing a rebound and it was well worthwhile cash-locked investors pulling out of those investments to put their money to work. “There are better things to do with your money right now.”

Stambulich doesn’t disagree about the timing issue. “If you bought one of these CPPI products [see box for more on this] that became bonds after the GFC and had five or six years to go on the loan, the best time to get out was 18 months ago when the Reserve Bank was aggressively reducing interest rates,” he says. At that time, people could abandon their products and get back 90 cents in the dollar. But the fact is, they didn’t, and as interest rates have risen, the amount investors can get back has fallen to about 80 cents. The RBS proposition today is that “we will get you out of this thing worth 80 cents that will never be more than a dollar and give you exposure to upside with NAB in the middle providing capital guarantees.”

RBS doesn’t buy the product: the investor sells it back to the issuer they bought it from. Consequently, in theory, the investor could do anything with that money: there’s nothing magical about the RBS Restrike, nor does it pretend to be the only option. “We’re saying: here’s another option. You can crystallise your losses; you can keep paying interest and get your money back; here’s another option.”

As for demand, RBS reckons there are about A$500 million of cash-locked products being held out there. It’s very hard to tell – everything is unlisted so one cannot find it in stock market data – but when one considers the dozens of CPPI-backed investment series sold by groups like Macquarie, HFA, Perpetual and others in recent years, it looks a reasonable estimate.

RBS and other new products represent a shift in approach away from products that tie investors to a long-term loan to make the investment. Increasingly, investors get to walk away if they choose. Macquarie’s Flexi 100 Trust series, whose latest incarnation opens to investment in November, is an example of this: it has a five and a half year investment term, with capital protection applying if it is held to maturity, but if the investment starts to look like a dud earlier on, investors can abandon it on a quarterly basis without being committed to making further investments. “Whereas if you remember three years ago, generally you invested for a full five-year term and if you wanted to exit you couldn’t,” van der Westhuyzen says. This might not sound much of a concession – if you walk away, you lose everything you’ve put in – but it’s the same principle that Australian investors have been comfortable with in instalment warrants for years. “Everything tends to be non-recourse loans with walk away features in them now,” confirms George Lucas. “Where a product is capital protected with a loan you can now break away without any penalty, which was a big pain in the other products.”

Stambulich says: “If I’m going to lend you money to buy a you-beaut structured product, there’s got to be some way to structure that so that instead of locking you into a five or six year loan, you can walk away.”

“In all the years I worked in Australia [he is based in Hong Kong now] I never heard a complaint about a client buying an instalment warrant over BHP. If the stock halves, they can walk away from the debt: they haven’t put a house on the line and they’re not going to get divorced.” Applying those principles to structured products means a product where “You buy it because you like it but every year you have the option to go on or not.”

“That has really resonated,” he says, “because people are thinking: that’s better than me being locked into a financing arrangement for five years where if the asset doesn’t perform, I’m stuck with it.”

BOX: Has anything changed?

Capital protected products seem to be back with much the same zest they ever had, but there are some differences in their appearance.

“A lot has changed in the last two years, without a doubt,” says Peter van der Westhuyzen, executive director of Macquarie’s specialist investments business. “The overarching principle we use now in developing products is to focus where possible on long term investment and short term flexibility.”

One is the ability to walk away from an investment, described in the main text. Another trend is that the method of providing the capital guarantee has changed somewhat. In the run-up to the financial crisis a model called CPPI (which stands for constant proportion portfolio insurance), also known as dynamic or threshold management, became popular. These involve keeping a balance between risky assets and a riskless asset, typically a zero-coupon bond, with the money shifting towards the riskless asset if things turn bad.

It’s through this structure that many products have become “cash-locked”: stuck with all their money in the riskless asset until maturity, with nothing at all exposed to what they originally hoped to invest in. CPPI is less popular now, and the earlier methods of a zero coupon bond plus a call option are back in vogue. “Nobody is really doing CPPI products anymore,” says George Lucas. “Everything has gone back to plain vanilla structures.” Additionally, he says that products tend to be shorter dated: where seven years was common before the financial crisis, the average is now around three years.

Another is that, where at one time people would buy structured products that gave them exposure to all sorts of weird and wonderful things, “people are more selective on the underlying investment now,” van der Westhuyzen says. “A lot of questions are being asked about that investment, which is a good thing: if they don’t understand what they are investing in, they won’t invest at all. There is a massive drive for simplicity and transparency.” Lucas adds: “We have a product linked to Asian stocks, to South Korea, Hong Kong, Taiwan and Singapore. It gets good flows but these days it’s nothing like what goes into products around the ASX 200. Everyone is going back to what they know.”

In terms of the industry, one sees less of some of the international banks who used to be active here, like JP Morgan and Credit Suisse, Goldman Sachs JBWere and Merrill Lynch (since absorbed into Bank of America anyway), but more of others, like RBS (whose team here is fundamentally the old ABN Amro business).

There are, though, some products that combine apparent capital protection with some real risks. These operate by selling a put option in order to increase the yield of the product, and carry capital protection provided the market doesn’t fall too far, perhaps 40% – but if it does, that protection doesn’t apply. These have been sold by Citibank (devised by Tony Rumble’s team), among others. They are more commonly sold by private client teams than to retail; some are troubled by them since one hardly has to look to far back to remember that the market just has fallen 40%.

In addition, new areas of protection have emerged. An example is income protection, which features in retirement income products like ING’s MoneyForLife. This provides investors guaranteed income for life – something quite different to a capital guarantee. It works by identifying a protected income base, calculated from the capital invested at retirement, and there is then a promise to pay 5% of that each year for life, regardless of whether the individual outlives their original amount of income. The guarantee in this case is provided in ING Life Limited – which is a separate statutory fund set up, under APRA oversight, specifically to provide the guarantee, with its own capital backing.

More of this is expected. “Income guarantees form the largest part of this market in the US,” says George Lytas, head of product development at ING. Total fees on the product, include investment management, a platform fee and the cost of the guarantee, vary between about 2 and 2.5% depending on which of three underlying funds is selected.

Does it make any more sense to buy structured products than it previously did? Many planners are unconvinced. “It is much harder to sell a structured product to financial planners now,” says Paul Moran of Paul Moran Financial Planning. “Many planners and advisers have recommended structured products in the past and they haven’t lived up to their promise, which has created a lot of tension with clients. Advisers are very sceptical now.”

BOX: ASIC

Structured products took a hit in July when the Australian Securities and Investments Commission launched a stern review of 64 capital protected, structured and derivatives products. Among other things it warned that the differences between products meant that the idea of a guarantee could mean different things, without a strict definition; that there were often substantial break costs; and that despite being more expensive than simpler investments, they did not necessarily bring better returns. It found shortcomings in areas including foreign exchange, warrants and futures contracts, and issued a strict warning about disclosure of funds investing in other funds in tax have jurisdictions.

ASIC also noted that more than a quarter of self managed super funds are invested in capital guaranteed investment products, and warned these investors of hidden risks. “A lot of people may invest in these products more now because of the financial crisis and feel that there is comfort because they are guaranteed, but we don’t want them to feel false comfort,” ASIC commissioner Greg Medcraft said in an interview in the Australian Financial Review in July.

CASE STUDY

The Alpha RESULTS Series 7, structured by Tony Rumble’s Alpha Structured Investments and sold and marketed by Citi, is an example of the sort of structured product that is being sold to investors today. This particular sale ended on September 17, but with seven series already completed, another is expected to follow swiftly.

This product shows a lot of the characteristics of post-financial crisis products. It has an 18-month term, much less than the five to seven years that had become commonplace before the financial crisis. It promises daily liquidity, again in contrast to previous products which might only allow you to get out once a quarter, and even then might sometimes stop you doing so. It also has a straightforward underlying investment – that is, it’s exposed to a handful of blue chip shares like AMP, Wesfarmers and Rio Tinto, rather than some exotic foreign stock exchange or odd commodity.

What it does have in common with previous products, though, is offering something that at first glance seems too good to be true: “high levels of enhanced income of up to 16.5% per annum, paid monthly, irrespective of the performance of the shares in the investment portfolio, and with conditional capital protection.” In fact, that’s the conservative version, called the Income Strategy: another approach, the Growth Strategy, offers “the prospect of preset minimum growth of up to 20.5% plus any upside and conditional capital protection”.

How can this be? Behind the scenes, the backers of this deal are selling put options on the stocks. Because markets are very volatile, those put options are quite lucrative for sellers. But actually, the performance of the puts is not really your concern as an investor, it’s just how the bank is making its own money from your investment. The key things for the investor, ultimately, are that Citi itself doesn’t go under, and that the conditional capital protection isn’t breached.

So what does that mean? What’s the “conditional” bit? In most cases, this means that at the end of the term, you get paid at least your investment (in BHP shares or in cash, or you can be rolled into a similar product). However, it’s subject to something called a barrier level, which is 60% of the initial price. If the lowest performer within the reference asset (the portfolio of blue chips) falls below that barrier level – in other words, falls 40% or more – then the capital protection no longer applies.

If that happens, then instead of getting your money back, you get the performance of that lowest-priced share. In theory, that could be nothing, although that would require a major blue chip to go under. It’s highly unlikely, but then again it was highly unlikely that the market should fall 50%, and it did exactly that less than two years ago.

Correspondingly, some financial planners are queasy about selling these as capital protected at all. “I like them, but I wouldn’t push them as a capital protected offer,” says Sulieman Ravell at FundFocus. “It has a role as part of a broader portfolio and it’s an attractive diversifier, but it’s completely different to all the other capital protected products around. I wouldn’t like to see people putting a big chunk of their portfolio in there.”

The product disclosure statement says there may a financial adviser fee of up to 2.2%, and an arranger fee of up to 1.65%.