Deconstructing Structured Products
16 April 2010Every bull market is the same; an investment theory – or theories – emerges to explain why this boom is different, why the market upward spiral will continue apace. Of course, it’s bunkum; if there’s one investment truism is that markets are cyclical.
In the last bull market, which started after the 1987 crash, Modern Portfolio Theory (MPT) achieved cult status – an investment elixir. It postulated that an investment could be added to a portfolio to increase the return while reducing overall portfolio risk; in short, diversification. Funds were managed to a benchmark, the risk measured as tracking error, and the fund managers’ performance was judged against these measures. Success was judged on outperforming the benchmark – even if the fund lost value.
These were the key strategies for sophisticated investors – select a suitable benchmark that was composed of various investments to spread the risk among several different investments to benefit when each type is doing well, while limiting exposure when one or more are performing badly. Then manage the portfolio to this benchmark. The maths behind MPT simply provided investors with greater peace of mind.
In the event, the Global Financial Crisis demonstrated that MPT couldn’t accommodate investors who were blind-sided by sparkling promises of returns without proper consideration of risk. Quite simply, their appreciation of risk simply didn’t factor in the cataclysm that was the GFC – or products such as CDOs.
Balancing risk and return is always a tricky business. Some investments are certainly more risky than others, but conversely, never taking a risk would leave you stranded by the side of the road, unable to get to the other side.
So how to achieve it? Structured products are one effective way to tailor the risk and return in an investment portfolio and to construct a risk/return profile more suited to a client’s needs
First, however, the investor has to consider were risk comes from. Second the investor must realise it is absolute returns that count.
Most people think of risk as loss of capital, or principal, but that’s not the full story. Sure, there is capital risk - where you lose your money. But consider inflationary risk, where the investment’s rate of return doesn’t keep pace with inflation and thus the return on the portfolio is insufficient to meet the income needs of the investor. Remember the 1970s – when you were earning 14% for your cash but inflation was running at 15% – and that was before the extra bite from taxes and other charges.
There’s also liquidity risk from the unavailability of funds at important times; legislative risk, where government regulatory changes can affect an investment’s return; longevity risk, where the investor outlives the value of their portfolio; and default risk, the failure of the company in which you invested.
With risks coming from all angles, the investor is faced with spreading it through the basic core types of investment, and many advisors use benchmarks involving the main asset classes: cash (or equivalents), fixed interest, property and shares. Which is why structured products can play a critical role for investors in navigating risk. They offer:
- Capital protection, the true measure of risk for a retail investor
- Guarantee an income stream to a retiree no matter how long they live
- Exposure to products that have higher correlation to inflation and accessible to the average investor such as commodities or even products directly linked to CPI.
However, they are not foolproof. For example, structured products cannot insure against legislative risk.
Advisors are recognising the potential of structured products in managing risk and to help them achieve alpha (returns uncorrelated to market behavior) rather than seeking benchmark-like returns.
It has been slow progress as there has been a degree of negativity – some of it deserved – associated with these products. For example, some capital protected products used 100% investment loans to create tax effective structures and provide access to different markets not normally accessible to investors.
Although these products worked as outlined in their offer documents, investors are now locked into loan repayments with little hope that the returns from these products will cover it. Then, of course, there are the (infamous) CDOs, an internally geared structured product based on the debt markets. The risk profiles of these were poorly understood and the structured product providers have learnt a harsh lesson.
It’s up to the investor to inform themselves and the adviser to guide them into their risk/reward comfort zone. If you seek higher returns, you will live with more risk; conversely, lower returns come with less risk.
It would be great to know when markets are going to outperform or underperform – but we don’t. We can only have an educated opinion. By using structured products to assist in managing risk it can allows us to maintain exposure for times when markets perform and limit losses when they don’t.
*Gabriel Carey works for the boutique fund manager Instreet
