Structured product evolution

Clive Moore, managing director of IDAD, says advisers are set to benefit from a revolution in the structured product market.

A quiet, but swift revolution is under way in the structured product market. Last year’s clear out of ‘boutique’ providers seem set to continue, with ‘direct from manufacturer’ operations becoming the norm. While one or two specialist firms should survive to the end of 2010, the landscape will be dominated by banks promoting their products directly to IFAs.

Such a change will bring a number of benefits for clients and advisers alike, most importantly much-needed clarity. If advisers and investors choose a product from a poorly-rated institution which subsequently defaults, at least it will not come as a surprise, and the FSCS should not have an undue burden to pass on to other advisers. Counter party identification should be unavoidable, with advisers able to make a clear decision as to the suitability for a given client.

Very few UK structured products can be criticised for being expensive, but with the distribution chain shortening and strong competition in the sector, clients should get even more value from their investments in the future.

There are rarely more than two or three product shapes that price well and are popular with investors at any particular time. While there will be innovation, UK IFAs have learned the more complex a pay-off is, the wider margin it usually pays to the issuing bank. Advisers should be able to make simple comparisons of product offers based on the strength of the counterparty and the terms on offer.

21st century product

The structured product market is finally developing in a way to match the needs of 21st century advisers. The days of mass mailings that appeal to one-off ISA investors are largely behind us, and products are now designed to complement the existing financial planning process. A secondary market for structured products continues to develop, driven by tighter valuations form issuing banks. Also, demand from discretionary managers who have realised the benefits of using structured products in their portfolios.

The use of fund structures has increased, and this year has seen the first launch to IFAs of a UCITS III fund (CitiFirst UK Autocall fund) with daily liquidity both ways and full platform flexibility.

The use of fund platforms has risen hugely in the past five years and, in spite of some wobbles over how platform choice fits into the principles of the RDR, the growth is set to continue. The rationale behind platform use is well-established and accepted. However, until recently, it has been very difficult for advisers to incorporate structured products into their portfolio construction process because of their rigidness and unsuitability, or unavailability for platform use.

The new UCITS III structures work just like any traditional mutual fund, with daily prices, the ability to adjust the size of the holding (up and down) and no hard maturity dates to prevent efficient tax-planning. As a result, they are suitable for all fund platforms and can be incorporated whole-heartedly into client portfolios.

For pension planning, the security provided by government debt that collateralises some new structured products provides welcome reassurance for investors who have limited time to recover from any losses in traditional investments. The clearly defined investment terms also suit shorter-time horizons perfectly and, with the ability to draw down from the investment holding, modern structured products will build on the popularity already enjoyed in the sector.

Offshore bonds

The use of offshore bonds as investment wrappers remains popular with advisers, both as efficient tax management vehicles and as the engine behind a number of trust arrangements.

The Personal Portfolio Bond rules preclude ‘highly personalised’ assets, and this has ruled out most structured products in the past, with the occasional exception of some structured deposits. The use of mainstream UCITS III investment wrappers removes any barriers, as far as use in offshore bonds is concerned and opens up a whole new market for structured products.

The clearly defined investment returns available with structured products, combined with the use of G7 government bonds as collateral, make them ideal for most trust arrangements and particularly popular with wealthier investors, the two groups that make up most of the offshore bond holders.

Easy selection steps

Every adviser selects products according to a set of criteria that works well for them, but the following approach may help incorporate structured products into that process.

When modelling a client portfolio, the key elements are: risk to capital, investment length and asset allocation. All three interact and affect each other, but structured products deliver clear attributes in every category. The universe of structured products that are suitable for flexible portfolio planning is small, but growing all the time, so it is worth looking at each element separately for a given product.

Buying a structured product issued by a single counterparty is equivalent to buying a bond from that issuer, and this is how the level of risk should be assessed. For example, would you hold 20% of a client’s portfolio in a bond issued by a particular bank? A number of structured products now deliver fully collateralised structures. The question may be: would you hold 20% of a client’s portfolio in gilts and bonds from other G7 governments? The answer will be quite different, and you could find the use of a structured product significantly reduces the overall risk of a portfolio.

Structured products can deliver excellent risk-adjusted returns, but it is important the underlying equity index or commodity fits with the client’s overall portfolio objective. The FTSE 100 is enormously popular as an index because of investor familiarity, but it is also delivers terrific diversification both geographically and in terms of industries. The days when it was dominated by big UK financial services companies are long since passed. A passive link to the FTSE 100 can allow for wider investment in the rest of a portfolio.

Do the investment terms suit the client profile? Is regular income or more general growth required? A popular pay-off at the moment is the Autocall, which delivers growth even if the underlying index has not grown at all. In an investment environment where few are predicting strong growth in the short to medium term, it is obvious why this approach is popular.