Structured products – shaken, but not stirred?

Andrew Wilkins, Executive Director at Catalyst Investment Group, discusses the outlook for structured products in the wake of the Keydata and Lehman Brothers scandals and the suitability of these products for the retail investment market.

Ever since the collapse of Lehman Brothers last year, attention has been focused on structured products and, in particular, their suitability for the retail market. The glare of the spotlight will only intensify over the next few months, following the revelation that Keydata was the victim of fraud through the apparent liquidation of assets backing some of its products.

With the collapse of Lehman Brothers, opinion focused heavily on the quality of counterparties backing a financial product, with the overriding message that your guarantee is only as good as the party supporting it. That a financial player as large and established as Lehmans could collapse forced the industry to take a long, hard look at itself. Intermediaries have since become much more alive to the credit-worthiness of those backing a fund and are conducting their own rigorous analysis irrespective of the brand name. Providers have also responded to the challenge, with most players disclosing much more information about their counterparty relationships to the benefit of all.

Just as the financial community was becoming a little more comfortable with the idea of structured products, the Keydata debacle shifted the debate enormously. On the one hand, the case has sometimes been dismissed as an isolated incident of fraud which could have happened within any area of the investment universe. Yet more detailed consideration has inevitably questioned whether such fraud is more likely to befall a complex, structured product. Argument moved on from counterparty risk, to questions being asked about the very nature of structured products, the level of risk attached to all third parties and administrators connected with a given fund, and whether these products are simply too opaque. Should retail investors steer clear?

The simple answer to this question is a resounding ‘no’. While on the one hand, arguments have been put forward that conventional mutual funds are far simpler and investors have the protection of investing directly into an asset, any such sweeping statements are misguided. Just as you would never dismiss every single mutual fund available to an investor, so to dismiss all structured products is hasty and ignores the huge differences – including in quality – in products available.

While it is too early to tell what effect Keydata will have on the preferences of investors and the recommendations of financial advisers, the signs are that the reputation of structured products may have been shaken in recent months, but not enough to stir up a frenzy of investors heading for the exit. Indeed, a recent survey by Virgin Money found that 27 per cent of advisers would recommend structured products for cautious investors, outstripping their preference for corporate bonds (23 per cent), and UK income funds (9 per cent). The current investment climate has simply made the essential proposition of most structured products too appealing to ignore: participation in any upside, and a fairly substantial degree of protection from any downside. Platforms such as Novia have recently announced their intention to include structured products on its platform, making it much easier for advisers to consider their role alongside more mainstream funds.

Yet this begs the question: what will the appetite be for these and other more complex products in the long term? Arguably, we could and should see much greater appreciation of investment products which will guarantee a certain element of return to investors. For institutional and retail investors alike, the financial crisis has brought home the need to create much greater diversification within the investment portfolio as a whole, and the difficulty of using other non-equity asset classes to diversify away from market-related risk.

Notably, a number of providers are claiming that there is much greater demand from the market for structured products which are not FTSE-centric, so as to diversify away from the risk to the portfolio as a whole of being invested in equities, and specifically the FTSE 100. Other providers are using structured products as a way of creating inflation-linked offerings which are able to return original capital invested and link returns to inflation. In view of the very real threat posed in the medium term by inflation as a result of loose monetary policy, the capacity to “inflation-proof” part of a portfolio is clearly an enticing prospect.

My own view is that it will be hard at the point of recovery to ignore the appeal of conventional equity funds as, over the investment horizon of a structured product, these may well deliver a better return to investors as well as dividend-related income. More interesting to advisers should be the ways in which alternative assets should be used to provide genuine portfolio diversification in the future, while acting as a source of (fairly) predictable income or growth.

Now is the time for IFAs to do their homework for clients and engage with a far broader array of investment solutions than they have done in the past. Yet, in so doing, advisers and their clients may be in a position to emerge from the peaks and troughs of the market’s harrowing cycles in far better shape than we have achieved up until now.