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Given the number of practitioners of financial advice to private investors, it is inevitable that from time to time some of those investors will seek, for a variety of reasons, to change their adviser.  Consequently, potential clients will arrive with a portfolio of investments which they have acquired as a consequence of advice given by a previous adviser.  Perhaps surprisingly, it is often possible to identify the type of institution with which they have previously dealt simply by looking at the components of their existing portfolio.

In our experience, one of the giveaways that their previous adviser was a private bank is the preponderance of a number of what can be grouped together under the classification ‘structured products’.  The term covers a multitude of different vehicles but they all have some essentially similar characteristics.  In essence, a structured product, also known as a structured note, comprises a fixed term bond and one or more derivative instruments such as options.  From the investor’s perspective, the purpose is to provide an investment return profile over the term of the product which is different in some way to what might be expected from simply investing in public bond or equity markets.

The simplest type is made up of a zero-coupon bond and a call option on either a market index or one or more individual securities.  The bond element pays no interest but instead delivers a predetermined capital value at the end of its term (commonly five years) to return the original investment.  This enables it to be purchased at a discount, the value of the discount then being available to purchase the option and to provide a profit margin for the issuer.

This gives the investor two potential outcomes.  If the option expires ‘in the money’ (the option’s price is lower than the prevailing market price of the underlying asset) then they receive the value of the bond at maturity plus the profit on the option less the issuer’s costs.  However, if the option expires out of the money, they receive only the value of the bond, which equates to their original investment.

The latter can sound like a good outcome in that the investor has not made a loss, as they might if they had owned the underlying asset and its price had fallen over the period.  However, there is no free lunch in investing and since only the nominal value of the original investment is returned, they have foregone any income that might have been generated and unless inflation is zero, also experienced a loss of purchasing power over the period. Furthermore, they have forgone access to their capital during the investment term as early withdrawal is often impossible or subject to a penalty.

Other structured products may aim to deliver a higher income than the underlying asset, although this is usually at the cost of reduced or no downside protection.  In some cases, products are designed to close early if the underlying asset achieves some predetermined return; these are known as ‘kick-out’ products.  Investors in products where this is triggered can potentially find that they are now subject to a taxable gain in a year where they did not expect it, as well as having to find a suitable alternative in which to invest for the remainder of the original term.

Although I remember many issues being targeted at professional advisers some years ago, the target market currently is typically unsophisticated private investors.  Such investors have no other way to access the offered return profile and they typically have a poorer understanding of the characteristics of structured products than the institutions which issue them.  I recall someone whose business was advising institutions on creating them telling me back in the 1990s that the structured products offered to retail investors are typically the other side of a transaction which the issuer wanted; for the issuing banks, they are a profitable line of business.  They provide a means for investment banks to issue debt at a cost below that of market interest rates as well as the opportunity to add a markup which is difficult for the end investor to calculate.

Interestingly, structured products are not widely available in the United States, where a regulatory requirement for investors to sign a declaration to have read a 183-page form prior to investing tends to deter unsophisticated investors from purchasing any options-related products (which is presumably the intention).  However, they are widely sold by banks in Europe as alternatives to savings accounts and, as noted above, frequently feature in portfolios constructed by UK private banks for their retail clients.

One of the features common to all structured products compared to alternatives such as index funds is their greater complexity.  An author prone to cynicism might suggest that complexity is to the benefit of the issuer as it can make it easier to exploit consumers who are less well informed about costs, risk and expected return than investment professionals, particularly when, as a 2017 study[1] found, it comes to products targeted at income-seeking investors,.

Costs

Although it is difficult for both consumers and financial professionals to calculate the inherent costs of structured products due to their opacity, fortunately there are some academic studies which have considered this aspect.  One such[2] looked at 64 issues and found that their offer price was around 8% higher than fair value, while in 2018 another[3] found that a large sample of products offering enhanced income yields had annual costs equivalent to 6-7% when compared to appropriate risk-adjusted benchmarks.

Given this, it is perhaps unsurprising that such studies[4] frequently determine that the average returns of structured products are negative, underperforming simple portfolios constructed from bonds and equities.

But what about the protections?

Although investors are promised a return of their original capital, it is important to appreciate that most structured products are not government-backed and therefore the strength of this promise is dependent on the ability of the issuer to meet its obligation.  As investors in products backed by Lehman Brothers discovered during the global financial crisis of 2007-09, the failure of the counterparty can affect the security of their investment and after Lehman declared bankruptcy, investors in structured notes which it backed were scheduled to receive only around 20% of their original investment.

One of the most common features of financial scandals is where investments which were promoted as being at low risk turn out to be anything but that.  When many investors see the phraseology used in marketing structured products, such as ‘protected’ and ‘guaranteed’, they understandably see this as an indicator of low risk.  It is unreasonable to expect most private investors to have a detailed appreciation of how to assess credit risk, particularly when there is evidence (2007-09 again) that even market professionals can struggle with this.  Equally, identifying costs and future expected returns is difficult, particularly when products are complex.

Conclusion

Structured products offer a classic example of an opportunity for information asymmetry to result in poor outcomes for consumers.  Issuers hold all the cards in terms of knowledge of pricing, risk and expected return and they can employ their knowledge of the terminology which appeals to investors (such as ‘low risk’, ‘high income’ or ‘downside protection’) to attract them while minimising any mention of the aspects which it is harder for them to evaluate.  Most investors have an exaggerated fear of stockmarket crashes and this makes it easier to persuade them to buy something which apparently protects against them.  When it comes to the underlying asset, linking returns to something which has recently been in the headlines for positive performance can make a product even more appealing, even though good recent performance results in a higher price and consequently reduces its future expected return.

As with most investments, it is likely that there will be some structured products which do genuinely offer a good solution in some circumstances, although if your portfolio contains multiple examples of them, it may be appropriate to consider whether that applies in your own case and to seek a second opinion.

This blog is intended for information purposes only and no action should be taken or refrained from being taken as a consequence without consulting a suitably qualified and regulated person.  Your capital is at risk when investing.  Past performance is not a reliable indicator of future results and forecasts are not a reliable indicator of future performance.

[1] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2289890

[2] https://experts.illinois.edu/en/publications/the-dark-side-of-financial-innovation-a-case-study-of-the-pricing

[3] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3223427

[4] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2350285

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