Navigating structured OEICs

Martin Morris discusses the pros and cons of investing in structured product OEICs.

Mention UCITS III or OEICs and most IFAs will at least have some familiarity with the concepts, even if they cannot necessarily describe them in great detail. Apply these terms in a structured products context, however, and there may be more than a little head-scratching in some cases.

And for good reason, given structured product OEICs are a relatively new phenomenon.

While terms and conditions for structured product funds vary, they usually have a designated life span of three or five years and aim to return the investor’s capital in full at the end of the term.

They also offer the promise of upside potential, from a capital growth standpoint, should the performance of the indexes they are linked to, such as the FTSE-100, meet certain targets. Alternatively, they may provide a designated level of income, if specified targets are met.

Lehman Brothers demise

The structured products industry has undergone profound change since the collapse of Lehman Brothers in September 2008. Indeed, if the investment bank’s demise taught product providers and investors alike one thing, it was the fact the issue of single counterparty risk had hitherto been grossly underestimated.

For investors who saw their capital evaporate, the debacle brought into sharp relief the fact capital guarantees provided by funds given financial backing by third parties was not necessarily worth the paper they were written on if those parties subsequently went bust and creditors could lay claim to the assets concerned.

In the interim, low-cost structured product providers have largely disappeared from the scene.

Also, the spectre of investors seeing some or all of their capital wiped out is likely to become a thing of the past as providers wake up to the need to build in additional protective measures.

Nowadays, financial service giants marketing UCITS III OEICs, such as Citi, Aviva and Morgan Stanley, are in the ascendancy. The net result is the name on product literature is more than likely to be the name of the counterparty as well as the fund’s administrator.

Clive Moore, managing director of specialist structured product consultancy IDAD (Investment Design & Distribution) – and the company behind the recent launch by CitiFirst of its UK Autocall fund – notes that UCITS III OEICs will mostly be structured to avoid single counterparty risk. For example, CitiFirst uses G7 government bonds as collateral, so there is no risk to investments if Citi defaults and no delay in realising value.

What are UCITS III OEICs?

UCITS III is the regulatory framework and fund structure allowing for hedge fund-type products to be distributed to retail investors locally throughout the EU. Most UCITS III funds are set up either in Luxembourg or Dublin.

OEICs, meanwhile, are collective investment schemes open to UK investors. They differ from bog-standard UK unit trusts in that they have a single pricing mechanism, rather than the usual two prices for buying and selling units.

This is a key point because the added liquidity available through OEICs gives product providers greater flexibility in terms of offering these types of products as part of larger portfolios, such as offshore bonds.

From a tax standpoint, many structured product providers have used fairly aggressive tax structures to ensure growth is taxed to CGT, says Moore. With the new model, HMRC has been far more assertive in questioning structures. The OEIC removes any concern for investors or their advisers, he adds.

The composition of structured product OEICs may vary but the major point to take on board is investors know at the outset the maximum return their investment can yield. Being linked to a benchmark (such as the FTSE) they also will not become a hostage to a given manager’s investment style and the negative implications that may have in some cases.

There are still downside risks, of course, and failure to meet specified targets could prove costly. As a practical example let us suppose that after five years the FTSE finishes below where it was at the time of a fund’s launch and the product’s terms and conditions state the return of the initial capital will be reduced on a 1% for 1% basis. Hence, if the FTSE is down by 30% at maturity, the investor will self evidently be returned only 70% of their original capital.

Similarly, there are products where maximum income payments are contingent upon certain criteria being met. For example, a fund may offer say 3% on a semi-annual basis – but only if the FTSE has traded within a specified range throughout each discrete six-month period the fund is running.

Suppose a fund has an ‘accrual range’ of 3,000-7,200 yet the FTSE trades only within this range for 50% of the days during a given six-month period, the reality is the corresponding income payment will be reduced by 50%, working out to 1.5%.

On the other hand, if the FTSE trades within this range every day, the investor will receive the full 3%. It is also worth noting just as your downside is limited, so is your upside. Therefore, if the FTSE doubles in value over the next five years, the value of your investment will not.

Moreover, if you simply receive a return of your initial capital in full at maturity, assume the capital value of that investment will have been eroded.

Identifying appetite for risk

While greater clarity/transparency in terms of how these products operate is needed, advisers must also identify a specific client’s appetite for risk from an investment standpoint.

Beyond viewing structured product funds as medium-term investments that offer some degree of diversification through investing in indexes or baskets of stocks, consideration must also be given to checking out the credit rating of the issuer and whether it would be better, all things being equal, to plump for an issuer with a lower credit rating that offers better terms and conditions product-wise, or to play it safer by opting for an issuer with a higher rating.

Putting all caveats aside, there is little doubt structured product OEICs are now entering the mainstream as product providers address previous industry issues and provide new-found flexibility for these funds to be incorporated into larger portfolios.

The industry is growing up.