Structured products have held up in Covid crisis

A new breed of defensive funds may stand investors in good stead, says Cherry Reynard.

During this unsettling period in markets, there has been much discussion around those investments that can defend capital in declining markets.

Government bonds and cash are an option, but investors must give up any real hope of an above-inflation return; absolute return funds could fit the bill, but have historically proved disappointing. Almost entirely neglected, however, are structured products, which in most cases have protected investors.

Any discussion of structured products invariably tends to include their chequered history, particularly the legacy of so-called precipice bonds. In reality, after more than a decade of regulatory scrutiny, the sector is arguably more disciplined and products more carefully constructed than for the conventional funds sector. Certainly, those holding a structured product today may be happy they have it as part of their portfolio mix, following the steep market falls in early 2020.

- Did defensive funds protect investors during the market sell-off?

Two types of product

There are two types of structured products: structured deposits and structured investments. Structured deposits are savings accounts offered by banks and building societies. Capital is not at risk, but the amount the investor receives at maturity is related to the performance of an index. In contrast, structured investments are created by insurance companies and banks. The return will also be linked to the performance of an index, but capital is at risk.

For example, a structured deposit may offer 30% return if the FTSE 100 is higher than 90% of its starting level after six years. With these products, it doesn’t matter what happens to the index, investors still get their initial investment back. While the current market rout could see investors missing out on their 30% if the FTSE 100 doesn’t recover, they won’t lose their money.

In the bad old days, the current market rout might be a cause for concern for the capital at risk products. Products were often structured with a clause that meant if an index breached a certain lower point, investors wouldn’t get their money back. However, these ‘low points’ tend to be far lower today and, in general, the product doesn’t kick investors out if it hasn’t hit its target – it simply rolls over to the next year.

The industry has moved to extend the maximum possible term of the investment to as long as 10 years, an initiative led by financial advisers Lowes Financial Management. As such, the recent rout may mean that investments taken out when the FTSE 100 was at its highest will not be maturing at the first opportunity – or perhaps even their second or third (unless the FTSE 100 makes a dramatic short-term recovery). However, there is no actual loss for investors because they do not need to sell. Equally, the potential return increases for each year the investment is held.

Zak de Mariveles, chairman of the UK Structured Product Association (UKSPA), says: “We have seen a significant fall in the FTSE 100 this year. At the same time, index volatility for the first three months of 2020 was 44%, compared to an average since 1984 of less than 16%. It is the third-biggest distinct peak of volatility in the FTSE 100’s history, exceeded only in 1987 and 2008.”

He points to recent research from Structured Edge, which looked at how capital at risk products had been impacted, and, importantly, whether these lower thresholds had been breached: “The group looked at 766 FTSE-linked structured products and mapped out how much the FTSE would have to fall from current levels in order for capital to be at risk at maturity. The first observation was that the FTSE is currently above the capital repayment threshold for all 766 products. The highest threshold – the one most at risk of being breached – is still 9% below the current FTSE level, and this product doesn’t mature until June 2028.” The highest barrier level for any product maturing before January 2022 is at 4173, nearly 30% below the current levels.”

Most of the products available on the market today are linked to the FTSE 100, says Ian Lowes, managing director of Lowes Financial Management. The group’s website, comparestructuredproducts.com, shows that around two-thirds of products are based on the FTSE 100 index. For Lowes, it is an important indication of how the sector has simplified and matured in recent years: “There are no contracts linked to a mixed basket of commodities that depend on the inter-relationship between the price of cotton and corn. There are no contracts linked to baskets of shares. Almost all the plans are linked to the FTSE 100 or another major index.”

Mark to market

Although there may not have been any direct breaches for structured products, some investors will receive annual valuations showing the investment is worth less that the money invested. This is a ‘mark to market’ figure based on how much an investor might get were they to surrender the contract today. There is a secondary market for contracts, but it is designed as an emergency liquidity option for investors and Lowes cautions that investors generally won’t get a great price. He adds that these mark to market valuations can be low in the early years and if markets are depressed, and don’t tend to be a good indication of real value: “It pays to ignore this daily ‘noise’ and just focus on the outcome,” he says.

David Stuff, managing partner at Levendi Investment Management, says that analysis of funds of structured products may be a better way to assess their performance in turbulent markets, rather than looking at maturity values. There are a number of such funds, including the Mattioli Woods Structured Products fund, the Levendi Thornbridge Defined Return fund and the Atlantic House Defined Returns fund.

These funds will generally include more sophisticated institutional structured products as well: “Typically these funds had been doing very well, but in the depths of the crisis they fell as far as the index, if not further. This is because of both the explosion in volatility and the falls in markets. That said, they have generally recovered quickly and more so than the index.”

The main risk for structured products outside the problem of not hitting their intended target return, belatedly discovered in the depths of the financial crisis, is counter-party risk. But even when Lehman Brothers went bust in 2008, no structured products investors got less than half of their money back; and banks have substantially restructured since then.

Lowes says: “In most cases, the counter-party is a household name – Goldman Sachs or one of the French banks. If it were to go bust, investors are seen as senior unsecured creditors. It can take a long time to get the money back, but they should recover some of it.”

The fall in markets should see the next wave of structured products offer relatively attractive terms, says Stuff, though there is a lead time on new products. “Retail investors can only really buy structured products in the form of retail plans, and there will often be a six- to eight-week window between marketing and strike date. The products should look good value with an attractive risk/return profile.

“Going forward, the yield on equity markets has collapsed. High-quality government bonds don’t yield much. Corporate bonds have a chance of corporate default. Providers are willing to underwrite falls in the equity market; therefore, structured products could generate good returns from here,” he adds.

There are two lingering criticisms of structured products. The first is cost, and certainly they are often more expensive than the equivalent retail fund – Investec charges around 2% for the “fixed costs and charges for administering and marketing”. Equally, they can have unexpected add-on charges: Meteor charges an extra 0.25% for paper-based communications, for example.

The other issue is whether investors would simply be better just riding the market’s ups and downs, because, over time, that has usually given a higher return.

However, Lowes believes that the recent market turmoil has shown the value of structured products as part of a blended portfolio: “Investors may not know when they are going to mature, but they can deliver a positive return even in difficult environments. I don’t know anyone who can predict what’s going to happen next. Structured products deliver a defined return in defined circumstances. In a severe market collapse, many investors will be delighted to own them.”

- Funds and trusts that thrive in bull and bear markets

Funds of funds provide easy access

Funds of structured products provide flexibility, as they run indefinitely rather than having a fixed start and end date. When structured holdings mature, they are replaced with new products.

These funds also provide diversification, with a spread of products targeting different indices and in some cases using plans from a range of providers. For instance the Matteoli Woods fund aims for an annual return of cash plus 6% over rolling three-year periods.

The AHFM Defined Returns aims to provide “medium to long-term growth via exposure to a diversified portfolio of defined return investments linked to global equity indices”.

Funds of structured products

Notes: * launched 31 January 2018. ** launched 1 October 2017. Source: Trustnet, to 29 April 2020