Why structured products must regain trust

Smart Investor magazine, January 2009

When markets have fallen as far as this one has, people know they want to invest – possibly even to gear – but they can’t quite bring themselves to do so for fear of getting it wrong and losing more money. For such a dilemma was the structured product invented.

Structuring typically involves creating a vehicle to get exposure to a particular asset class, with a twist – sometimes capital protection, sometimes leverage, sometimes both. Often, your money never makes it into the asset class you’re exposed to, be it a local or foreign stock market, a commodity or a currency. Instead, the bank (it’s generally banks rather than fund managers who put these things out) conducts some behind-the-scenes wizardry to create the effect of being exposed to that asset, while finding some other way – such as an option contract – to provide capital protection.

Many structured products have gained a terrible name over the last 12 months, particularly outside Australia, either because they have turned out not to have the liquidity they had promised investors (so investors couldn’t get their money out when they needed it), or because the capital protection has turned out to be worthless (often because the bank entered into a trade with a counterparty to provide it, and the counterparty has either gone bust or has become victim to some other crushing misfortune that prevents it meetings its obligations). “Capital protection has lost its meaning,” says one private banker, who says his clients are “no longer interested” in structured products after the last 12 months.

Some planners and managers just don’t trust them. “I really don’t like them at all,” says Charles Leyland at Leyland Private Asset Management. “As a general rule of thumb, you can rarely improve your risk-return scenario by structuring your product, unless it’s tax driven,” he says. “By definition structuring costs money – you’ve got to pay someone to structure it. Clever and sophisticated investors generally steer clear of them.”

But manufacturers, such as Macquarie, Citi and JP Morgan, argue there is a place for them, and indeed structured products are still being launched in this environment. An example is the ASX 20+ Series being sold by JP Morgan, now into its third incarnation. Like many structured products, this runs two separate portfolios. One, called the equity dynamic portfolio, gives you exposure to 20 of the biggest listed companies on the ASX. The other, called the coupon dynamic portfolio, is designed to generate yield – in its latest version by using a basket of JP Morgan’s proprietary investment strategies. The allocation between the two varies according to market performance but can be as low as 20% of your money and as high as 200% – the 200 coming about because the fund uses leverage to magnify your exposure. The idea is you get capital growth if the stock market bounces back, a coupon of up to 10% if it’s not, and the whole thing is capital protected provided you hold it to maturity (which is seven years).

David Jones-Prichard, vice president of equity derivatives and structured products at JP Morgan, argues that leverage makes sense in this environment provided you’re backed by capital protection. “If the question is, should you gear into a market where you can lose a large amount of your money, the prudent answer is a categorical ‘no’.” He says. “But should you gear into a product that is capital protected? I think you get a different response.”

Jones-Prichard has noticed a change in investor appetite towards structured products, but only in terms of the underlying asset. “This year you’ve really seen investors start to come back to things they know,” he says. “In the past a lot of structured products in the Australian market had given exposure to emerging markets, alternative energy, foreign exchange, commodities – things investors don’t know that well. Now, because of the massive volatility and severe wealth destruction, investors are looking for things they can focus on and know better, and Australian shares is one of those things.”

Other issuers have taken a similar approach. Earlier this year Macquarie was selling the GP100, a structured product from Credit Suisse offering exposure to Australia’s 20 largest listed companies, with capital protection, and a potential maximum participation rate of 250%. Once again, the investment was split between a physical basket – the 20 largest Aussie stocks – and a hedging portfolio, made up of option contracts with Credit Suisse to provide capital protection.