Graham Bentley: Why it’s worth revisiting structured products
Last month I opined on targeted absolute return funds, suggesting that more than half the products struggled to beat their bare minimum objectives, let alone their benchmarks, more than half the time. Our research has confirmed the hypothesis that targeted absolute return funds do not, as a cohort, deliver positive returns in all market conditions, and where individual funds do, it is less than half the time, with little consistency.
I’d suggest structured products are an option that advisers could consider including in their portfolio of investment solutions. I can sense your scepticism already, so let’s first revisit the negatives.
You may be experienced enough to remember a variant of structured capital-at-risk products known as precipice bonds. In the late 1990s, these products offered a pre-defined and significant annual income or capital growth – for example, 33 per cent over three years and a return of capital even if the referenced index or basket of securities fell by less than 20 per cent.
However, the quid pro quo was that a fall of more than 20 per cent would trigger an instant equivalent reduction in the valuation, falling by one per cent for every further one per cent fall in the index, then accelerating to fall by two per cent for every one per cent the market fell by 30 per cent or more.
While your potential gain was 33 per cent (whatever the market did), and your loss was zero down to a 20 per cent fall, you stood to lose two-thirds of your money if the market ended more than 33 per cent below its starting level, and all your money if it fell by 50 per cent or more.
Few advisers anticipated the fall-out from the bursting of the dot-com bubble in 2000 to 2003, when major indices fell by almost 50 per cent, so there was a furore when shocked investors saw their valuations plummet, verging on total loss.
The products did exactly what they said they would, as they were contractually obliged to. However, they had been marketed as low-risk investments to investors, especially by “household names” like Bradford & Bingley and Lloyds TSB. The marketing implication was “it has never happened, so it’s an improbable event and can therefore be ignored”. Those banks were fined, and investors compensated.
Advice firms like RJ Temple were ruined by compensation claims.
Lehman Brothers, on the other hand, was an investment bank that was “too big to fail”; a brand that advisers felt perfectly comfortable relying on as a counterparty to a contract. We now know its quantum leap into unrestricted risk-taking in the mortgage-backed securities market led to its insolvency, accelerated by credit markets drying up and the added momentum of a 70 per cent fall in its share price in a single quarter.
For structured product buyers, the irony is the “real estate hedge fund disguised as an investment bank” carried small exposure to structured products in the UK. At around £100m, Lehman represented around one per cent of the structured product market and 99 per cent of holders of products backed by other banks were, from a counterparty risk viewpoint, unaffected.
Over the years since its insolvency the recovery rates for investors in structured products linked to Lehman Brothers have crept up to almost full repayment of capital.
Lack of governance and lazy due diligence were not confined to structured products and their counterparties. Those of you old enough to remember the bizarre revelations of the Morgan Grenfell affair will appreciate reliance on marketing material and third-party affirmation of fund groups’ bona fides cannot protect investors from a rogue individual or slipshod governance.
The recent collapse of GAM’s absolute return range is a further demonstration that, as I discussed in my previous column, the quest for positive returns in all market conditions encourages ever more complex strategies and questionable quality of holdings. Retail investors in particular are at risk from ill-governed fund managers tempted to make bets with other people’s money in a game where they may be no more than amateurs.
In theory, structured products are better placed to deliver an objective akin to absolute return. Their unique selling point is that they create contractual obligations upon the investment bank standing behind the product as the counterparty, to deliver what they offer. Unlike absolute return funds, investors benefit from legally-binding obligations that pre-define parameters for risk and return, with the variable instead being timing.
Today, investment banks operate under much stricter scrutiny than 10 years ago. The modern structured product sector operates with far fewer providers, almost exclusively through advisers and wealth managers. Participating banks are better capitalised since the global financial crisis, with an acute focus on best practice governance, stringent product design and development procedures that preceded and helped create the blueprints of Mifid II and the Product Intervention and Product Governance Sourcebook.
However, banks act as counterparties to structured products only because it’s a cheap way of raising capital; the potential for weaker banks to offer over-optimistic returns to attract hundreds of millions of pounds from investors means that due diligence on counterparties and providers is paramount. The biggest players are known as global systemically important banks and under Basel III these giants (HSBC, JP Morgan Chase etc) have to conform to greater capital adequacy requirements.
But if advisers want to investigate structured products further, as with any investment, due diligence on counterparties is critical. For many this will be unfamiliar territory. With that in mind, in next month’s column I’ll go through the key criteria, where to find the data and how to analyse it.