10. Structured Products & Hedge Funds

Thursday, 5th July 2012 10:42 - by David Harbage

Having looked at collective investment schemes last week.

we now turn to look at two other investment vehicles which may have attractions in the quest to find solutions for long term savings: structured products and hedge funds. Relatively recent and popular investment offering amongst private individuals, they appear to offer ‘the best of both worlds’: apparent safety of capital, plus the prospect of enjoying cash-beating returns, or higher performance according to the subject - equity or other asset type – of the structure or fund.

Structured, sometimes known as a stock market linked, products are pre-packaged investment strategies based on particular derivatives, such as options, swops or futures used to gain access or exposure to a single or basket of securities, indices, commodities, debt or foreign currencies. This variety of asset illustrates that there is no single, uniform definition of a structured product, but their best known feature is probably the "principal guarantee" function, which offers protection of capital if held to maturity. For example, when investing £100, the issuer simply places a specific sum into a risk free bond with sufficient interest or appreciation to grow to £100 over the five-year period. This bond might cost £90 today and after five years it will grow to £100. With the other £10 the issuer purchases the derivatives needed to perform whatever the investment strategy is. A common example of a structure would be to provide a return over five years linked to the FTSE100 index (often capped at say 25%), plus a return of the capital invested. Theoretically, a wealthy investor could do construct this themselves (by acquiring appropriate proportions of a gilt strip and a future, CFD or other derivative), but the costs and transaction requirements of many option and swap instruments would be beyond most individuals.

Structures were created to provide greater certainty of return than could otherwise be expected from the underlying asset type or delivered by standard financial instruments available in the markets. Accordingly, these products can be used as an alternative to a direct investment, as part of the asset allocation process to reduce the risk exposure of a portfolio, or to utilize an anticipated trend in the market.

Unlike an ongoing open-ended investment, these structures are not always readily available ‘on the shelf’ products as there can be real difficulties in assembling them, on suitably attractive terms, according to market conditions. For example, the current low interest rates provide little cushion for the non-cash portion (meaning the resultant growth opportunity is limited), the banking crisis has led to a lack of liquidity in the over-the-counter (OTC) market (which provides the equity or other asset return) and a low appetite for risk impacts the price of the derivative and the availability/costs of counterparties. Being an offering which requires a close date for receipt of investable monies, the issuer of the structured product has to contend with potential change in market conditions (most notably impacting the option price) that can disappoint (reduce the indicative terms to) the end investors, or render the product useless (resulting in the offer being withdrawn if the terms are uncompetitive).

Structured products are not free of charges or risk: while costs are not visible – as investors focus on the headline offer terms, by reference to the perceived guaranteed products – the other prime risk (beyond issuer or counterparty) for investors is the prospect of receiving disappointing returns relative to alternative forms of investment. This ranges from comparison with the purchase of the underlying equivalent assets (5 year gilt and FTSE100 index, per the earlier example) to the wider spectrum of other investments, which could have proved more suitable or beneficial in risk adjusted reward terms to the client. Investors should be mindful that structured products do not typically produce income (as the return comes at maturity, or upon early encashment, if allowed); something which they probably would have received from a direct investment in equity or bonds. Whether the return generated is deemed to be income or capital – for taxation purposes - should be stated within its terms & conditions.

Another consideration for prospective investors surrounds access to their capital, as most structured products do not feature on a secondary market and have limited or no opportunity for redemption before the end of their term. However, where a secondary market does exist, this could facilitate tactically beneficial trades by investors with shorter term horizons. Where an investment is necessarily being held for a number of years, investors will appreciate that any lack of flexibility could prove to be expensive and serious consideration should also be given to the resultant reinvestment risk/opportunity. 

These products can be useful in procuring tax-efficient incremental income (relative to the very low returns currently available on 5 and 10 year gilts) or matching a known (both sum of money and date required) liability. In determining the usefulness of structured products, investors should be mindful of the costs (initial fee is typically embedded into the terms), access before maturity (investigate liquidity and tightness of spread – in part impacted by size of issue – in any secondary market, probably operated by the issuer), timescale (a 5 year term minimum is required for ISA qualification) and how reliable will the product be in capturing a particular anticipated event (relative to alternative, perhaps traditional, investments). In addition, investors should always be mindful of their wider finances and ensure that structured products are correctly viewed in terms of how they are constructed (composed of cash, bonds; linked to equity, commodity?) and compliment existing assets, rather than distort the overall asset mix and balance of risk-reward.

In more strategic or speculative terms, structured products can be used to gain exposure to (or protection from) specific anticipated events in a controlled way. For example, investors could obtain 200% upside exposure to European equity over 1 year period with a 25% downside capital limit (if European equity falls more than 25%, the protection disappears and the investor bears the full cost of the fall). This would be achieved via derivatives - enabling a geared position to an appropriate index - with another providing the downside protection, to meet the explicit terms of the product. Structures could capture anticipated weak or negative outcomes (short strategies, effected by selling futures) or be the means of effecting specific ideas through bespoke constructions. For instance, an investor might construct a ‘pair trade’ to favour listed gold shares (perhaps using the i share S&P Gold Producers ETF), versus the spot price of gold. Using structured products as a defensive hedge can be effective. For example, an income hungry portfolio could sell its underlying bank shares, and reinvest a smaller sum into a structure appropriately geared to the FTSE350 Banks index – to reduce tracking error, on any pickup in sector.

While investment professionals may view structured products as effective financial engineering, some private investors have voiced concerns about the complexity of these financial instruments – sometimes viewed as a ‘black box of tricks’ – and the financial media has highlighted instances of unsuitable advice, proffered by issuing banks in particular. The latter typically refers to the proposition’s perceived ‘no risk’ guaranteed returns, and being locked in to products which had appeared to be the equivalent of a cash savings account. In terms of understanding total risk, it is important for the investor who owns several issues to assess the cumulative toll of issuer and counterparty risk of all the structured products they own.

Financial advisors and portfolio managers have reduced their appetite for these products (£9bn total sales in 2011, £12bn in 2010), primarily by reference to the proportion of an individual’s total asset worth committed to structures, but a higher quality of advice and more discriminating use has been evident via a broader product offering – featuring defensive strategies, such as inflation insulation or as a means of gaining exposure to a wider range of assets, such as commodities. Banks have sought to improve their reputations, and respond to the well-publicised issuer or counterparty risk, by setting up collateralised products (which place cash equivalent to the daily value of the structure into a separate fund), have capped the amount of a personal client’s total assets in structures (typically to a 25% weighting), raised risk ratings on products (to better reflect inherent underlying assets), and have had less incentive or opportunity to issue (influenced by low gilt yields which have diminished the attraction of terms).

Hedge funds represent another potentially big subject, but essentially they are an alternative asset type which seeks to manage assets or monies to deliver a specific return of cash (say Bank rate), plus a certain amount on top (typically between 4% and 8%). While they can be either open-ended (unit trust-like) or closed-ended vehicles, their investment objective (and prime feature) of endeavouring to deliver absolute or positive actual returns can be achieved by using various strategies and financial instruments which are not used – or allowed to be used – by more traditional collective investments. In pursuit of capital preservation and cash-beating returns, hedge funds will typically adopt both ‘long’ (owning various assets such bonds, equities, foreign exchange) and ‘short’ strategies. Positions in the latter, reflecting a fund manager’s negative view on an asset, will be achieved by using derivatives (such as futures, options, CFDs).

Hedge funds have historically been viewed as only being suitable for sophisticated (knowledgeable) and professional investors, with a high minimum sum for investment (ranging from £0.25m to £10m) effectively representing a significant barrier to new entrants. Managers typically charge higher annual management fees than applies to traditional open ended funds, featuring performance based fees which can restrain the eventual return to the investor. While the prospect of a fund manager being incentivised in this way may seem appealing, the historic performance of hedge funds has been mixed. Notwithstanding ‘survivor bias’ (whereby funds that have failed and wound-up, inevitably disappear from the peer group), the track record of delivering attractive actual returns – which reflects a major bias to US and European (rather than UK £-based) hedge funds - tends to be reasonable over the longer term (ten year plus), but unimpressive in more recent years.

Many equity or bond fund managers (who informally have managed portfolios of securities they would choose to sell or not own) have extended the scope of their traditional ‘long only’ open-ended collective funds to accommodate ‘short’ positions, which enables them to potentially add incremental returns. These collectives typically specify such strategies, such as several ‘80%-20%’ funds in particular limiting the extent of their short exposures (which, necessarily, feature higher risk – as an incorrect short call has limitless monetary downside exposure, by contrast with a long position whose loss is limited to the investment). Another investor concern surrounds the difficulty of realising many of the assets held by hedge fund managers, which could result in a considerable delay should the fund receive a major cash call, be closed or wound up.

By contrast with most financial products, hedge funds and their managers often seem particularly mysterious – to personal and non-personal investor, alike - and their structure (frequently offshore based, private companies) and underlying investment portfolio strategies appear opaque. For example, the latter may be based on trying to capture small anomalies in market prices around the world – from arbitraging stocks (upon corporate takeover situations) to extracting margins from foreign currency pricing. Asset managers and advisors promoting these funds have sought to minimise the risk attached to following any one hedge fund strategy, or manager, by investing in a collective vehicle which owns a number of hedge funds. This makes good sense, as well as making these funds accessible to private client investors who would not otherwise have sufficient monies.  

Structured products, which share the use of derivatives, but feature specific terms of reference, represent clarity by comparison. There has been considerably publicity given to cases, such as the Bernard Madoff one, where hedge fund investors have not received the anticipated positive returns, and this part of the financial industry is likely to receive further close attention by the authorities and regulators. In January 2012 the Financial Conduct Authority (a new UK consumer protection watchdog) warned that it would ‘ban products deemed harmful to the public’, suggesting tighter regulation may be on its way. While investing in a product or vehicle which seeks to deliver only positive returns has natural appeal, prospective investors should investigate the underlying assets and be mindful that “you don’t get owt for nowt” (anything for nothing)  and “if something sounds too good to be true, it probably is”. Next week, as we near the conclusion of the series looking at long term savings options for private individuals, we will summarise our findings on each of the asset classes and consider the different approaches one can take to progress an investment plan.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.