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View the article online at http://citywire.co.uk/wealth-manager/article/a674510

Nick Sketch slams expensive and overly complex structured products

by Emma Dunkley on Apr 24, 2013 at 12:02

Nick Sketch slams expensive and overly complex structured products

Nick Sketch, senior investment director at Investec Wealth & Investment (pictured below), explains how investors can gain access to Europe with downside protection, and play UK dividends through structured products. 

What are some of the most interesting products you have seen recently?

Over the past few months I have seen lots of new FTSE autocalls issued, and these have been needed to replace existing products that have been repaid. However, equities are higher, credit spreads are narrower and volatility is right down. This means prospective returns are a lot lower than they were a year or two ago.

Some investors have responded by keeping their return targets up and increasing risk tolerance. This is sometimes done by raising the final barriers, or by using a less robust credit or by basing returns on the ‘worst of’ two indices.

What are some of the risks involved?

Apart from anything else, ‘worst of’ structured products effectively mean that investors are selling volatility and buying the correlation between the two indices.

Although terms for the latter have improved recently in some areas as correlation has fallen a little, investors are generally still not getting great value for taking a bit more risk.

Value for money plus risk awareness means other investors are casting the net more widely. Rather than replacing a lower risk holding with a new autocall, some are opting to move that money away from structured products for now.

Instead, it can make more sense to use your structured products allocation to replace part of a portfolio’s equity exposure by buying a participation product.

Taking HSBC as a high quality example, you can buy a structured product today with soft protection in six years 40% below today’s market level, which also offers 200% of the capital increase in the S&P 500 index.

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9 comments so far. Why not have your say?

Archimedes' Mate

Apr 24, 2013 at 14:38

Maximum 40% loss, 260% of the index's upside, no currency risk; too good to be true? Who underwrites these things? Lehman Brothers?

Let's go back to 2008 and do it all over again!!!!

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Anonymous 1 needed this 'off the record'

Apr 24, 2013 at 16:56

how is 40% downside considered 'protection'?

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Londoner

Apr 24, 2013 at 19:27

When will they stop talking about 'protection' ? If the counterparty fails (as it did for thousands of UK savers in 2008), these products have no protection against capital loss.

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Stephen Tiley / PensionsManager

Apr 24, 2013 at 21:54

Yes Londoner except that now counter-parties have to post collateral daily - and in Gilts or Cash. In fact quite a few didn't lose with Lehmans because of the daily collateral posted then which provided security. It didn't stop the pain of having to find new counter-parties, but these protections are pretty secure otherwise investment banks wouldn't be able to write the huge LDI 'bets' for pension schemes (inflation SWAPS etc).

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Chris Taylor, MD, The Investment Bridge

Apr 24, 2013 at 23:47

The first two comments do (as is so often the case with comments about structured investments) indicate more about the commentators' lack of working knowledge of structured investments than they do about structured investments themselves.

The 'how is 40% downside considered protection' comment? As described, this is a barrier level, a buffer if you like, which means that the index can drop by up to 40%, from its strike level, ie starting level at the outset of the investment, without the investor suffering any loses from this degree of market downside. It may be monitored during the investment term (known as an 'American' barrier) or it may only be monitored at maturity, in say 5 or 6 years time (known as a 'European' barrier) - a significant extra level of protection. It is right to use the word protection in this context, as there is indeed protection from a defined level of market risk.

The 'Too good to be true' comment? Not at all? You really need to understand how structured products work. The terms are a legal obligation on the issuer, through the bond/security that they issue. What is 'promised' is precisely what will be delivered, unless the issuer goes bust. This article doesn't specify the issuer for the 260% terms, but it sounds like it could also be HSBC (as opposed to Lehman Brothers!). And if it's not HSBC it's likely to be another major international investment bank. No currency risk is the way most structured investments are written, though I prefer to think of this as a neutral feature, as opposed, necessarily, to being a benefit (albeit James Calder clearly identifies a benefit that he wanted, in having no currency exposure). As a flip side example, however, if I was investing in China at the moment, for say 5 years I would probably prefer the currency exposure, as opposed to being neutral (based on a view that the Chinese currency will be managed upwards in the future).

Londoner comment : protection from market risk, either fully (ie no market risk at all : a black and white hard fact) or partially (through a barrier, protecting from a specified level of market downside), should rightly be recognised and described as 'protection. But I concur with your point. I would suggest that 'capital protection' is an inappropriate general description, because, as you say, and at least without collateralisation, counterparty risk always exists - unless within a Deposit wrapper, when there will be no downside market risk, ever, and counterparty risk should usually be covered by FSCS protection. I would like to see the industry refer to protection from market risk' more precisely, in instances where credit risk prevails.

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Londoner

Apr 25, 2013 at 06:41

Chris, it that right that structured deposits have no downside ever? Product brochures usually couch their words carefully on this point.

A few weeks ago, an industry player published a blog article to illustrate how structured deposits work. He gave a hypothetical example of a product aiming to return the initial deposit after five years, plus an interest payment linked to the FTSE100 index. For each 100p invested, 85p went into a deposit that would grow to return the initial sum at maturity. 9p went into financial instruments to provide the FTSE-related return, and 6p went into expenses.

So what happens to capital protection if the deposit taker fails during the five year term before the deposit has grown sufficiently to return 100% capital? I would not like to put it to the test with FSCS.

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Chris Taylor, MD, The Investment Bridge

Apr 25, 2013 at 13:11

@Londoner. Agreed product brochure literature is usually careful in its wording, not over-egging FSCS cover, etc. This, by the way, demonstrating how far providers have come in response to regulatory scrutiny, guidance and rules - that and the fact that the industry is simply better these days. My understanding is that FSCS cover would protect a deposit that qualifies for FSCS cover (licensed UK bank deposit taker, etc) to the full deposit value, ie deposit made at the outset : it would not depend on what the deposit taker has done with the funds during the deposit term. It is fair to acknowledge that as with most SPs the terms promised apply at maturity, so if access is available during the investment term a loss (or indeed a gain) could still be crystalised, based on various factors, including internal charges (unlikely to be the 6% you detail now, post RDR :more likely 1-3%), market movement, interest rates, etc. A deposit is a deposit is a deposit, whether the return is promised as a fixed or variable 'cash' rate or calculated based on a structured link to a market, asset, etc. The return will be interest, taxed as such, etc. A structured deposit is a deposit, like any other deposit. I think consumers rightly can and do assume that and benefit from that.

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Londoner

Apr 25, 2013 at 14:49

Thanks for your view Chris. That's interesting. I had understood from the worked example that most went to the deposit taker, and a smaller proportion went into financial instruments and plan manager charges etc. If you are saying that 100% is classified by FSCS as going into a deposit, then I can see how FSCS cover would work. Some providers say they put the money into a 'bare trust' - does that mean that the 'bare trust' is the licensed deposit taker? FSCS can be difficult to to deal withh, so let's hope it never has to be put to the test.

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when will people learn....

Apr 25, 2013 at 15:41

terrible tabloid title for an article that's actually pro SP's. US SP mentioned has returned 6.62% (bid price you can sell today) since launching in March v index return of 4.6%. What's not to like about that? How do you do this? Give up the yield on an HSBC 6yr bond, sell downside risk on S&P and buy currently cheap calls. Very simple for anyone with a claim to be an investment manager to understand.

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