Why it's wrong to compare structured products with trackers

Sophie Barnett, executive member of the UK SPA, looks at how structured products can work alongside other investment types

Much has been commented on the IMA report published earlier this year that compared structured product performance to that of tracker funds. The report and the research contained therein has received some harsh criticisms from across the industry, with the UK Structured Products Association highlighting significant flaws.

However, the overriding message has been that perhaps such a simple comparison of the two investment types should never have been made in the first instance: structured products and trackers funds are designed for completely different investment objectives and therefore are not as comparable as the research indicates.

Structured products, like any investment product, carry inherent risks. The main ones are counterparty risk (the risk of the provider going bankrupt and not being able to meet their obligations to the investor) and market risk (the risk of the market performing poorly and not generating returns for the investor).

On the face of it, many think that adding structured products into a portfolio creates unnecessary levels of counterparty risk and for that reason should be avoided. The demise of Lehman as a structured product provider hit many investors hard, and awareness of counterparty risk has grown significantly as a result. But does this mean investors should dismiss structured products out of hand?

While it is true counterparty risk exists (as it does for most financial instruments), there are measures investors can take to help limit this. Like most things, it is a matter of balance. Having a high proportion of your investment portfolio dependent on the financial health of a small handful of counterparties is indeed a risky strategy. However, spreading exposure across different products from a selection of counterparties is key to successful portfolio diversification.

Aside from diversifying exposure across a range of counterparties, there are other solutions for investors who are looking to mitigate counterparty risk. Structured deposits are used widely by UK retail investors, as they combine the benefits of a structured payout with potential FSCS protection in case of deposit-taker default, subject to an £85,000 limit.

Other solutions that have been bought to market in recent years include collateralised solutions, including structured UCITS funds, where highly rated assets are used to secure returns. With the availability of such a variety of tools, investors are able to invest in structured products without taking on excessive counterparty risk exposure.

More traditionally, portfolio management has been about managing the balance between market risk and return, and this is where structured products can really come to the fore. The challenge when building a portfolio is to ensure there is sufficient upside exposure to meet an investors’ goals whilst minimising the risk of any downside.

Investors realise that a balanced and diversified portfolio can help hedge against market shocks, and structured products can have an important role in creating that diversified exposure. So how exactly can they help?