What is a Structured Product?

Much maligned structured products are back on the investor's radar as we seek post-retirement solutions that pay a sustainable income. But should they be avoided?

Emma Wall 17 March, 2015 | 3:06PM
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Emma Wall: Hello, and welcome to the Morningstar series, 'Ask the Expert.' I'm Emma Wall and here with me today is Rosie Bullard, Portfolio Manager for James Hambro & Partners. Hello, Rosie.

Rosie Bullard: Good morning.

Wall: So hot topic at the moment, structured products. I thought we perhaps could start with asking what exactly are they?

Bullard: Well, a structured product has a very broad definition. It's a pre-packaged product based around a series of derivatives; and really through a structured product you can get exposure to a range of different underlying assets. It could be single stocks, baskets of stocks, indices. You can get exposure to commodities, debts, foreign exchange. It's almost a definition a little bit like hedge fund, in the fact that it's very broad brush and can really encompass a range of different underlying exposure and risk being taken as well.

Wall: And a bit like hedge funds, there are good ones and there are bad ones. Structured products got tarred with an almightily bad brush a couple of years ago. What went wrong?

Bullard: I think it was really a lack of understanding in what the structured products were meant to achieve and indeed the risks being taken. So be it understanding counterparty risk; who is on the other side of those derivatives trades? And particularly in the financial crisis, understanding whether that counterparty may be at risk of default or not.

I think a lot of investors didn't understand how the structured product was going to achieve its end returns; i.e., if there were hurdle rates to be met; how are those hurdle rates going to be met and were there multiple hurdles that had to be met in order to provide the returns that were expected from the particular product?

There was also a lot of scrutiny about fees. The charging structure of the product itself, how was that calculated in terms of what the structure was taking, and indeed, the counterparty in terms of derivatives being structured around that note, how they're taking their fees as well. And a lot of them turned out to be very, very expensive when one opened up the car bonnet and really looked at what was inside the product itself.

Wall: You've mentioned the sort of wide ranging and often complexity of these structures. One of the things, I think, also added to that confusion is they could be called so many different things. Somebody might call it a structured product; some people might call it a guaranteed income plan; some people might call it cash-like investment, bond-like investment.

But the bottom line was these products were offering what looked like guaranteed income with capital preservation, which brings us to why they're beginning to be back in the investors' mind is because in this post-retirement space, now that we don't have to buy annuity, people are looking for the sort of product that these sound like.

They're looking for guaranteed income and they're looking for capital preservation. I mean what's the alternative if it is not an annuity and not astructured product?

Bullard: I think wherever one hears the word guarantee, you have to work out why is that guaranteed and what it's going to cost me in order to get that guarantee. A lot of investors are concerned about bond markets looking over value to the equities, perhaps having run too far.

But if structured products are based on those underlying asset classes anyway, it's going to cost you quite lot in order to buy a structured product that’s going to guarantee you an income and also guarantee you that you're going to have capital preservation.

And really it comes down to, as with any portfolio, understanding what that particular product is doing, why it's doing it, what your returns are going to be, what the volatility is going to be, and most importantly, how it fits within your overall structure; what have you got in the portfolio already, and what is the structured product going to provide in return.

Wall: And if you are not willing to pay those fees, what could people be doing to look in that - post-retirement space, with their SIPP perhaps?

Bullard: I think there has been a lot of scrutiny about SIPOs and what's going to happen post April 5 in terms of what people are actually going to do with that money. We've still got a very beneficial environment for long-term investors within SIPPs, where you can have very high levels of tax efficiency, be it capital gains tax efficiency or income tax as well.

If your portfolio is already structured with some high-quality yield equities, we don't feel a need to touch those investments at the moment. Equities, of course, have run a long way since the lows of the financial crisis, but in our mind they are not looking overvalued at this point.

You've always got to be careful with what you're holding inside your SIPP, as indeed any portfolio, what valuation point it has got to, and when you're going to take profits. But I don’t think there is a need to rush out of the door, sell all your bonds, sell all your equities and try and buy lots of capital protection when it could actually cost you a lot of money.

Wall: Rosie, thank you very much.

Bullard: Great. Thanks.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Wall  is former Senior International Editor for Morningstar