Rethinking the way South Africans can diversify their offshore wealth

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By Mike Abbott*

In these turbulent economic times, many South Africans are looking to send at least part of their wealth offshore, with the UK being a popular destination. Structured products offer investors the ability to pick from a diverse array of investments, ranging from low-risk to high-risk. All told, these kinds of products are a great way to increase your offshore exposure.

Structured products first arrived on the scene in the late 1980’s, but it’s only since 2000 that the market has grown to any scale. The failure of Lehman Brothers and the Precipice Bonds scandal in the UK between 1997 and 2004 led to structured products getting a very bad name. However, the term structured product covers a very wide range of possible products that can be tailored to a variety investors. I sat down for a chat with my colleague, Niel Pretorius, to discuss these products, and their variations.

Mike Abbott: So Niel, you’ve been advising on structured products for a number of years now. Can you explain the role you see a structured product playing in a clients’ portfolio?

Niel Pretorius: Structured products have a role to play in client portfolios for several reasons, the most common being the need for certain income, or where clients are nervous about the financial markets and look to gain more certainty in their portfolio.

Structured products do what they say on the tin; there is no ambiguity about the circumstances in which you will receive the pre-defined returns. They offer the possibility of high returns even if markets do not rise. They also offer a degree of protection against a decline in the level of the markets.

They offer higher returns than tracker funds under most normal market conditions and the risks you face, from changes in the market, and from issuer defaults, are clearly defined.

They also serve as a diversifier in the portfolio, allowing for returns to be generated in conditions where the other components of the portfolio may not. Lastly, the capital protection element gives clients a level of comfort when they are uneasy investors.

MA: Some people have described structured products versus traditional diversified investment portfolios as a small chance of making a big loss versus a bigger chance of making a small loss. Would you agree?

NP: The qualities of structured products – defined outcomes based on defined market conditions, plus potentially a degree of capital protection, and the ability to deliver in flat or even falling markets – means they can be useful to a client looking to achieve balance and diversification in investment portfolios.

For instance, a product that is linked to the performance of five individual shares with a 20% barrier issued by a bank with a low credit rating is, by its very nature, much riskier than a product linked to the FTSE with a 50% barrier and issued by a well-rated bank.

Clients need to be aware of and understand the risks. A product linked to the FTSE may serve you better than a diversified portfolio when markets are negative. If a 50% barrier on the FTSE is reached, markets would be in crisis and your other investments would also be massively affected.

A risk that a structured product does introduce is counterparty risk – the risk that the issuing bank might fail, in which case you would lose your money, unless the product is a structured deposit note. In this case you may be covered by the Financial Service Compensation Scheme, where applicable, up to £85 000.

The devil is in the detail – some products are inherently riskier than others. Make sure you understand the risks. As with any investment, your advisor should ensure you are aware of the risks. They are not an investment panacea but can complement an investment portfolio.

MA: Ok, so it looks like the barrier and the index link is the key to the potential risks and investment outcomes. How do you as an adviser evaluate the risks of the various structured products for your clients?

NP: First and foremost you strive to understand the client’s objectives, capacity for loss and attitude to risk, as you would in making any recommendation.

Complex products are likely to scare investors off. The usual methodology would be to ascertain what levels of capital risk the client is willing to take, the returns he seeks to achieve, and whether the underlying assets to which the product is linked are acceptable. For example, indices less likely to drop by large margins compared to four of five single shares. As a general rule, the higher the level of capital protection the lower the typical headline rate would be.

When deciding to include a ‘capital-at-risk’ structured product in a portfolio, there are generally two complementary methods to evaluate the risk of the particular product:

a) Highest expected gain

This is a combination of the conditional gain (instances where the return is 0% or more) and the probability of the gain (the chance of getting a positive return). This allows you to rank products which offer investors the highest probability adjusted return. Using this method, you can screen out products that offer a high headline return but have a low chance of achieving the result.

b) High win/loss ratio

This is the ratio of the expected gain to the expected loss. This typically uses both market and issuer risk and shows the units of upside per units of downside.

MA: There are three kinds of structured products: Structured deposits, capital protected notes and capital-at-risk notes. How do these differ, and how do you choose when to use which for your clients?

NP: The main characteristics of the products you mention can be summarised as follows:

1) Structured deposits

These are essentially fixed-term deposit accounts where, instead of interest being earned at a set or variable rate, the return is fixed but depends on the performance of the underlying asset, such as the FTSE 100.

So, for example, a deposit plan might offer 20 per cent return on the capital after three years as long as at the end of the investment term, the FTSE 100 is at, or more than, the level at which the investment started.

As with most UK deposit accounts, structured deposits usually include the potential benefit of protection should the deposit-taker become insolvent during the investment term. This protection is provided by the Financial Services Compensation Scheme and UK eligible claimants have a right to claim up to £85,000 per individual per institution in such circumstances.

2) Capital “protected” notes

Structured capital “protected” products are like structured deposits in that they are designed to return the original capital at maturity as a minimum. However, like structured capital-at-risk products, they are often structured as loans to a bank or other financial institution.

The returns for any capital “protected” note, including the return of capital, are dependent upon the counterparty, usually a major bank, remaining financially solvent for the full product term. These products do not have recourse to the Financial Services Compensation Scheme.

3) Structured capital-at-risk notes

These investments generally offer the highest return on investment, because as well as the reward of potential returns, there is the risk that the capital invested can be lost in adverse market conditions. The investor is offered a premium for taking the greater risk.

Many capital-at-risk products will protect capital unless there is a large fall in the markets. For example, a note may only reduce the capital returned if the FTSE 100 falls by more than 50 per cent. This event is only likely to occur in extreme market conditions.

Capital return is dependent upon movement in the underlying asset and the extent of any protection barrier. Also, rather than being deposits, structured capital-at-risk products most often take the form of loans to banks. The returns for any structured capital-at-risk plan, including the return of capital, are dependent upon the bank remaining financially solvent for the full product term.

Determining which type is appropriate for a client is a question of their risk appetite and capacity.

Conservative investors will attach more value to securing their capital with the potential of achieving better returns than what they would receive for cash, whilst balanced or more adventurous investors may be happy to take the additional risk of capital-at-risk products in order to achieve potentially higher returns as defined by the product terms. The general rule remains – the less risk you take the lower your likely return would be. Taking more risk means you demand a premium – higher returns – for taking that higher level of risk.

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