With structured products becoming ever more popular with fund managers I thought it would be useful to look at a comparison between the growing collateralised structured product market and the more traditional, bank backed structured products.

First of all, what is a collateralised structured product? The basic notion is that credit or counterparty risk is substantially reduced/removed from the trade. Collateralisation is widespread. It is used all the time in the financial markets by people who want a certain return but want to limit how much risk to the other party they take on. It is used widely in lending markets and also in investment products like ETF’s and UCITs funds to reduce the damage done to the investor should a default of the product provider occur.

Perhaps the most popular and certainly, in my eyes, the most credible collateralised structured product program is called COSI. This is a collateral program run in conjunction with the Swiss stock exchange where a pool of eligible collateral is placed externally from the bank to pay back investors in case of default. So on face value, this sounds great, it is what we have all been looking for, a way to get rid of counterparty risk and enjoy the true defined benefits of a structured product. But, what are the pros and cons of collateralised vs. non collateralised structures?

The main reason why you may want to opt for a collateralised product is, clearly, because you want the defined return of a structured product but don’t want the counterparty risk. If you buy a single bank backed product, in the event of default you will get back the recovery value of the bond. According to Moody’s the average recovery value for a senior unsecured bond (typically what structured products are issued as) in 2008 was 33.80%. This means that on average, bond holders got back £0.338 per £1.00 invested at par.

What then happens if the bank product provider of a COSI collateralised product defaults? The collateral, which would equal the value of the market to market of the product the day before default, is sold and you receive this in 30 day’s time. Compare this to investors who bought Lehman backed bonds and waited years to get their money back.

A nice feature of the COSI programme is that three independent parties value the product on a daily basis and it is this agreed value that determines how much collateral is posted each day. I prefer this scenario over the usual process where the bank issuer determines the value of the product alone.

Another key reason why I like COSI collateralised structured products is that, everything else being equal, they are more stable from a market to market perspective than single bank backed products. Why? Never forget that a structured product is just a bond with some embedded derivatives in. Being a bond, its value is effected by credit spreads i.e. the amount over the risk free rate a bond holder has to be compensated for taking on the additional credit/counterparty risk that bond comes with. This amount moves around every day as investors change their mind about the perceived riskiness of lending to that bank.  These credit spreads move around a lot, especially of late. RBS’s CDS went from nearly 400bps last December to 220bps at the beginning of February. That is a 9% affect on the mark to market value on a 5 year product (5 x 1.8%). Credit spread movements affect your structured product value a lot.

Luckily, you don’t have this issue with a COSI collateralised structured product, since if the value of the collateral goes down, they just post more the next day. You therefore avoid this additional complication on your daily mark to market value of the product, which is important when trying to create a steady portfolio return for clients.

The final point I want to make about COSI is that it helps me get comfortable about the level of financials risk in my portfolio. Typically there is always a point at which, no matter how attractive the structured product may be, you will not be able to increase your allocation to bank backed structured products due to the additional counterparty risk exposure. COSI allows me to mitigate this where suitable.

Should we just forget about bank backed structured products then? No. The pickup you get by taking the additional counterparty risk can be attractive in certain situations. Like any investment, it must be compared to the product you would otherwise buy. When looking to make an investment, we compare the collateralised product to the non collateralised one.  The key is trying to evaluate how much additional risk that bank issuer actually entails. This is notoriously difficult. Who knows what banks hold in today’s environment. Pre 2008 most banks’ CDS rates were incredibly low, around 0.1%. Now even the UK government trades at 0.65% and most banks trade at 2% i.e. at a level 20 times higher than their 2008 levels. If anything bank counterparty risk has gone down since then.

So, to collateralise or not? It depends on what you are trying to achieve. I am looking for defensive uses of the defined returns of structured products. In this scenario, I tend to opt for collateralised versions. If you are looking for riskier plays, then perhaps backing returns by a single bank is the best route.

Fund web provides an insightful article on the increasing popularity of structured products and the importance of their consideration for client portfolios.

The increased popularity is noted in the article due to the following:

1.    Increased IFAs research and understanding of the values of structured products;

2.    Investors finally comparing structured products side by side other investments rather than considering them as a satellite;

3.    Increased diversity and availability of Structured products on www.spgo.co.uk for example;

4.    Investors looking for risk controls if markets fall;

5.    Continued market uncertainty;

6.    Low interest rates.

Read the full story here

Investec Structured Products is the latest provider to launch a structure in UCITs III fund format into the UK financial adviser space. The move follows similar initiatives by Barclays, RBS, Citigroup and Aviva.

The first fund is to launch shortly and will be available via wrap platforms from a minimum of £3,000 per client. The first product will be a kick out (also called an autocall) and is likely to emulate Investec’s other kick outs but without bank counterparty risk.

Investors should however expect headline rates to be lower than Investec’s other kick outs since they are not taking on the same degree of counterparty exposure.

Whether the fund format will grow in popularity remains to be seen as they offer both pro’s and cons versus structured products created in plan format.

Here is a summary of the key differences between the fund and plan format:

Structured Product Plans

• Single bank counterparty risk
• Relatively higher headline rate compared to funds
• Sales usually restricted to once a week/month
• Typically not available on all wraps (Investec’s plans are available via SPGO however)

Structured Product Funds

• Collateralised return – in the event of a default by Investec your returns are unlikley to be affected
• Relatively lower returns compared to plans
• Tradable daily
• Benefit from the rigorous conduct rules of UCITs III
• Widely available on wrap platforms

Investors can view all available kickout structured products on SPGO.

Financial Advisers buy around £4bn of retail structured products every year. Sales have been buoyant over the last year since the low interest rate environment coupled with the fact that equities have already performed very well of late makes it harder for investors to find a reliable source of defensive returns for their clients.

The high demand for the defensive returns that structured products can provide is mirrored on the continent. One key difference however in how structured products are bought in the UK compared to in Europe is the delivery mechanism. Most financial advisors do not have access to security clearing systems in the UK which means that they can not buy the structured product bonds issued by major banks that back the returns of all structured product plans. This has lead to the “plan” being the favoured way for UK based financial advisers to buy a structured product. We believe however that sidestepping the plan wrapper and buying the underlying bond that powers the return of the structured product offers a number of key advantages for clients.

What is a plan? It works in a similar way to a fund register. Clients don’t hold the underlying bond that provides the return of the product, but instead buy units in the “plan” which gives exactly the same return. The plan is there to serve as an administration wrapper for the bond issued by the bank and that is it.

A key trend in the UK financial advisory market has been the growth of investment platforms that do have the ability to hold bonds. Why then do we need the plan wrapper? Its sole purpose was to provide the administration function which is now done by the platform.

More concerning is that if advisers are putting structured products on platforms, there is typically a doubling up of administration charges (once within the plan wrapper and then at the platform level). It is worth doing your homework here are there are free platforms available that specialise in structured products and can ensure you avoid the doubling up of administration costs.

Are there any other problems with the plan wrapper? Most products wrapped as a plan offer limited liquidity, perhaps sell only availability once every two weeks for example. This is in stark contrast with the intraday buy and sell liquidity offered on the underlying bonds.

This increased liquidity is good for three things. Firstly, having a good buy and sell price increases the chance that the price will be accurate from the product provider. Secondly, it is always nice to be able to buy at a discount to the starting price or to sell out and lock in profits if you want to. Thirdly, when you are able to consider the primary and secondary market the universe of products available to you increases a lot, increasing the likelihood that a suitable product will be available.

The increased liquidity is also good for firms who may run model portfolios and want to have a fixed percentage weight to a particular structured product. By accessing the secondary market you can then rebalance your portfolio effectively as the market moves up and down.

So buying the underlying bond that powers the return from a structured product typically means better liquidity and potentially avoids the doubling up of administration costs. Why then aren’t all structured products created in this way? Product providers are beginning to create products in bond format.

As more and more financial advisers recognise the benefits of buying structured products in bond format, as opposed to plan format, we believe product providers will start producing more and more products in this way. The death of the plan will banish a long held criticism of structured products, that they are not liquid. They are, you just need to buy the bond and not the plan. These bonds can be tricky to get access to which makes using a dedicated structured platform a good idea.

Gilliat has expanded its business into the offshore market with the launch of two new products, the Phoenix Autocallable and Quarterly Income Notes. Both products are only available via financial advisers and are available in GBP, EUR and USD.

The offshore venture is being spearheaded by ex RBS banker Andy Savil.

How to Compare Structured Products

As structured products continue to grow in popularity and size in the UK financial advisory market, so does the regulatory scrutiny over product providers and how advisers analyse, compare and use structured products for their clients.

Simple tools have emerged to allow advisers to analyse the wealth of product available to them but very little in the way of a clear and demonstrable framework as to how advisers could approach this problem has been provided. Let me shed some light on how we do things on spgo.co.uk.

There are three main steps we take when comparing structured products.

Step 1 – Compare the strength of the counterparty backing the returns of the product

With structured products, like any form of debt such as corporate bonds, the advertised return is only as good as the strength of the provider backing those returns. The primary inputs we look at here are the ratings from the 3 main credit rating agencies, namely Standard and Poor’s, Moody’s and Fitch and the current “credit default swap” rate which is the cost of buying insurance against a default by that counterparty. In addition we can go one step further and utilise balance sheet metrics such as the tier 1 capital ratio and the loans to deposit ratio which is a measure for how much of its deposits the bank has lent out. This gives us a sensible check on the strength of the counterparty and their perceived risk of default as judged by that market at that time.

Step 2 – Compare the product complexity and risk

Our next step is to assess a few of the key product return features. We consider the level of capital protection offered, looking at whether a product is fully capital protected at maturity or whether the return of the initial capital is dependent on the underlying index/stock not hitting a certain pre-defined level (such as 50% of the starting level of the underlying for example). If there is a level at which the product becomes “capital at risk”, then advisers should make sure they fully understand this condition and how it works. Does the product become capital at risk if the underlying index/stock hits the downside level at any point during the term or does the product just look on the final day of the product’s life? Clearly products that can become capital at risk at any point are more risky than those that only look at the level of the index on the final day.

We also look at the number of underlying indices/stocks the product is linked to and the volatility of these underlyings. What do we mean by volatility? Simply put we mean by how much the price of the underlying index or stock moves around. An index whose price on average moves by 3% a day is more “volatile” than an index whose price on average moves by 1% a day. Generally the greater the number of indices/stocks the product is linked to and the more volatile these underlyings are, the riskier the product is.

We then consider how complicated the product return mechanism is. We typically find that the more complex the product payoff is, the greater risk there is of the end client not understanding how it works.  Other things we consider are the investment term, with a longer investment term reflecting a greater risk in terms of the exposure to the counterparty for a longer period of time, the opportunity cost of being invested into that product and the increased sensitivity of the product to interest rates.

Finally we assess how much bang for buck we are getting. What is the maximum annual percentage return available from the product over and above what I can achieve by investing in (not so risk free?) UK government bonds?  The greater the potential return the better.

Step 3 – Compare the historic performance of the product

This is a bit of a moot point. One of the first things we are taught is that past returns are no indicator of future returns. Having back and forward tested thousands of products in my time, what I can say is that you begin to get a feel for which types of products perform well and which perform less well. Whilst relying on historic simulated returns alone sounds like a recipe for disaster, when combined with a number of other sensible inputs as above, it can be a useful addition to our due diligence.

What we do here is to calculate what an investor would have got back by investing into the product on any day over the last 10 years. Once we have the results (often thousands of simulations) we can quickly and easily work out the most frequent historical simulated return (the mode) and the average historical simulated return (the mean). The higher both of these returns are, the better the assessment for our comparison. Finally we consider the standard deviation (or spread) of the historical returns. The lower the spread the better.

By considering each of these 3 steps we are able to compare and rank structured products in accordance with risk and return. There are many different ways to approach the problem of comparing structured products but we feel the above approach is clear, simple to understand and, crucially, easy to explain to others like clients or the regulator should there be a need to do so.

To see the SPGO comparison tool please visit www.spgo.co.uk

With interest rates at all time lows and equity markets jittery, advisors are finding it increasingly hard to achieve the returns their clients demand. With RPI inflation still at 3.9%, the need to achieve these returns however is at the front of investors’ minds.

This search for yield has not gone unnoticed by companies and non financial issuance of corporate bonds has swelled as companies look to lock in low borrowing rates and investors pour money into corporate bond funds and ETFs. Flows into fixed income funds were at their highest level since October 2010 in January 2012 according to the Investment Management Association, and the GBP Corporate Bond Fund was the most popular fund sector.

A closer look at ETFs reveals a worrying trend however. Despite nearly $7bn of investor flows into High Yield Bond ETFs this year alone, data from Lipper reveals that over the past 5 years that the average ETF in this sector has underperformed its benchmark by 5.52% a year, mainly as a result of high transaction costs incurred during portfolio turnover according to the Financial Times.

What risk are clients taking on in return for the 6% – 8% annual return earned by high yield bonds funds over the last few years? Looking at the credit ratings of the bonds within one of the largest ETFS, the iShares High Yield Bond Fund, shows us that it has the vast majority invested into bonds rated BBB or below (also known as “junk bonds”). This is no surprise, it is a high yield ETF after all. That said, nearly 15% of the fund is invested into CCC rated bonds or below. S&P define this as a company that is “currently vulnerable and dependent on favourable business, financial and economic conditions to meet financial commitments.” Hands up who expects favourable economic conditions over the next few years.

What are the alternatives then? Rather than buy lower and lower rated bonds in order to get your return up, why not stick to lending to the highest calibre companies but to overlay something like equity market risk in order to achieve those high returns? A simple example we recently bought was a 5 year senior bond, S&P rated A+ where we receive 7% a year as long as the FTSE 100 is above 3,500 points. We get our initial capital (principal) back at maturity unless the FTSE falls to this 3,000 level in which case our capital is reduced in line with the underlying index.

What I end up with then is something akin to high yield bond returns, but backed by high quality credit, not the junk bonds within high yield bond funds. It is also listed and trades intraday like a share with a bid offer spread of 1%. Not bad.

Investors are becoming increasingly aware that one of the biggest drivers of long run returns on investment are the costs paid along the way (annual management charge, administration and dealing costs etc). This is largely due to the affects of compound growth. This realisation, in part, is responsible for the stellar growth seen in the use of passive investment products like ETFs.

If an investor wants to compare the costs of structured products and how they stack up versus the cost say of actively managed funds and ETFs, how can they do that? Funds and ETFs have their total expense ratio (TER) as a (not entirely accurate) estimate of the costs involved. What is the equivalent for structured products? Sadly there is not one really. What we can do however, is take the total cost incurred by an investor as disclosed (by law) in the product provider’s brochure and divide this by the number of years of the investment term (structured products tend to be closed ended/fixed term products of 5 years in length or more). When we do this, how do the costs of structured products stack up? I think you will be surprised.

Read my article in Citywire here.

The downgrade of banks’ and sovereigns’ credit ratings has fuelled concerns over counterparty risk and is spurring a move towards improved credit quality among structured products investors.

Yesterday, Standard & Poor’s downgraded Société Générale and Credit Agricole from A+, to A. while the ratings agency removed France and Austria’s AAA rating earlier in the month, leaving Germany as one of the only major eurozone economies with the top credit status.

The downgrades compound the current uncertainty surrounding Europe, while throwing the spotlight on credit risk and the extent to which investors are exposed to different levels of credit quality within structured products.

The uncertainty is helping to spur a move to products backed by higher-rated institutions and countries, as well as products with collateral.

Ben Murison, co-founder of structured products consultancy SPGO, said cautious investors who like the asymmetrical returns of structured products but are not keen to take on single name bank credit risk could look to collateralised products, which diversify and reduce counterparty risk.

He said: ‘One such product offers a potential return of 7% a year and the ability for the bond to be called prior to the five-year maturity date provided the FTSE 100 index is above a falling barrier each year, starting at 100% of the closing level of the FTSE 100 and then falling to 80% of the initial level in year five.

‘Investors can then credibly earn a positive return in a falling equity market. In terms of counterparty risk, the full mark to market value of the product is collateralised on a daily basis using bonds with a minimum of an AA rating. We expect the popularity of these high quality products that mitigate counterparty risk to grow strongly over the next few years.’

Although the downgrade of Austria and France to AA+ by S&P was not necessarily a surprise to many investors, it serves as a reminder of the importance of credit quality.

In the good times most investors are happy to pay away some of their gains to investment managers. Nobody minds paying a fee as long as the net result fills the coffers. In leaner times though, investors pay more attention to whether they are getting value for money or not.

Having a vested interest in the structured products industry (I am perfectly open about that), I am used to fending off the usual cry of “structured products are expensive!” Well I ask, “Compared to what?” What is the point in debating costs unless it is for the useful process of a real world comparison?

Given the UK is a largely fund driven market, it makes sense to compare the cost of the average structured product to an average managed fund. In this case I have to give credit where credit is due. The UK fund management industry has done a fantastic job of getting people to gloss over the cost of investing into their expensive products.

We need a sensible base to start our comparison from. According to an insightful article from Moneyobserver.com (click here to read it) their average conservative estimate of the all in cost for someone who invests directly (i.e. not via an adviser) into an actively managed fund is at least 3 per cent a year. This includes:

• Annual Management Charge (in part the cost for running the money)
• Auditors’ fees
• Actual trading costs incurred on running the underlying portfolio of shares/assets
• Any additional charges an investor is likely to incur from their wrap platform

How does this compare to the typical structured product? We need to compare like with like so I assume the average structured product has a life of 5 years. Typically the bank who creates the product will charge around 3% as a one off upfront fee for creating a structured product for a client. Over 5 years this works out as 0.60% simple interest per annum. What about any annual management charges, auditor’s fees, or the actual trading costs on running the portfolio? Typically these charges are all zero in the case of a structured product. What about the costs of an investment platform to actually buy the product? If clients invest via the SPGO Structured Product Investment Platform, then this is also free of charge.

What we have then is a typical “all in cost” of 0.60% per year for the typical structured product versus 3.00% a year for the average actively managed fund. This makes the average fund investment a staggering 5 times more expensive than the average structured product investment when bought via the SPGO Platform.

I can hear critics ringing in my ears already saying that it isn’t fair to compare an actively managed fund to a passive structured product. I disagree. The investor is interested in results, not how much sweat the fund management company has put in to get there. It’s like saying here are two hamburgers. They taste the same but one took me 2 minutes to make and one took me 20 minutes to make, so the one that took me twenty minutes to make is ten times more expensive. Pandering to the critics whims though, even if we compare a structured product to a typical passive ETF they still look attractive.  Assuming a typical TER cost of 0.40% per year for the average ETF and a platform charge of 0.35% per annum gives a total of 0.75% a year, still more than the 0.60% typical charge for a structured product when bought via the SPGO platform.

Structured products clearly then are cost efficient investments when compared to funds, sometimes by an order of magnitude.

Click here.

Investors are having a tough time in low interest rate environment. To read the full story click here.

The UK Structured Product Association responds to the IMA regarding their “comparison”  of the historic realised performance of index trackers versus gilt backed structured products.

The IMA study is in my opinion mis-guided. The UK Structured Products Association “ why, when pursuing this flawed research, the IMA did not choose to compare the returns [of the tracker funds] against any of its members active managed funds? Good question. We are still awaiting a response from the IMA on that one.

You can get the report from the UKSPA here.