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What if...?

Rob Kingsbury - 31/08/2016

A version of this article was first published in July 2012.

What if, it was not the mutual fund that had its origin in the Netherlands in 1774, and been issued in the US since the 1920s and the UK since the 1930s? Rather, the product with this long history in the market had been the structured product.

In this alternative universe, the reason structured products have become the dominant investment vehicle over the past 80-90 years is due to five fundamentals:

  1. They have defined terms and outcomes
  2. They have defined investment periods
  3. The potential return on capital is known from the outset
  4. They offer various levels of capital protection
  5. They allow effective tax planning

A typical product is issued in the form of a contract from a financial institution, usually a bank and its performance is linked to a benchmark, typically a single market index. Investors in a typical product will receive a known return on their capital at the end of the investment term, usually 5 or 6 years, as long as the benchmark is at least equal to or above the level it was when the investment started (the strike date). What investors particularly like about this is that the benchmark only needs to stay at the same level, i.e. rise 0%, between the strike date and the end of the investment term, or in some cases may even be allowed to fall by a certain percentage and the product will pay out the full percentage return. A simple structured product at present is offering around 24% return on capital after 6 years, even if the FTSE falls by up to 5%.

As well as offering this defined outcome – i.e. a set return on a known date, in defined market scenarios – typical products can protect capital, either 100% or against all but the most extreme market conditions (i.e. the benchmark has to fall more than 50% before the capital is at risk).

As might be expected, over the past 80 or so years the market has devised several variations on the product. One example is the autocall investment that offers a set percentage return on capital after a year if the benchmark index is at or above its start level on the first anniversary of the strike date. If the benchmark is below that level the of investment rolls over to the next year, when if the index is at or above its start level it will deliver twice that return and so on until the end of the term, normally 5-6 years. At that time, should the benchmark still be below the strike level, depending on how extreme the market fall has been and the level of capital protection chosen, investors receive their capital back or suffer a loss.

However, newer variations on these themes will pay a positive return even if the index is down (up to 50% in some cases) at the end of the investment term, which gives investors added opportunity to obtain the known percentage outcome.

The upside potential is balanced against the level of protection required, so that 100% ‘protection’ invariably results in a lower potential gain than those that have a 50% barrier built in but the former does mean that bar a substantial disaster in the market or the issuer of the contract becoming insolvent, the investor will receive their capital back intact.

Charges are set and payable at the start of the investment period - normally at no more than 3%. These charges are calculated in the original design of the product so do not affect the capital protection levels. The charges to affect the investment return, in that they govern the capital available for purchase of derivatives, but the investor knows that effect from outset in that the potential return is clear and upfront.

From a tax point of view, large numbers or these are growth products that fall under HMRC Capital Gains Tax rules and so gains can be set against individual investors’ CGT exemptions.

The main downsides to structured products are, of course, the potential for markets to fall dramatically and breach the capital protection barrier, or the financial institution which issues the contract to fail, in which circumstances the investor could lose some or in extreme cases, all of their capital.

Nevertheless, over the past 80 years investors have turned to structured products because they offer defined terms and investors know how long their investment will last, what return they will get on their capital and optional levels of capital protection they can balance against their attitude to risk.

New kids on the block

Now, a new product has been introduced into the market. It’s called a mutual fund. This product seems like a good idea. It invests in the shares or debt of trading companies and pools the investments of many different investors into ‘collectives’. Funds are run by fund managers, who use research teams to help them examine and select from the thousands of companies available and they build portfolios of the companies that they believe will make money for the fund. Using these strategies and in rising markets, funds could produce significant returns for investors.

However, compared to the highly popular structured products they would seem to have some disadvantages. First, there is no capital protection whatsoever and capital is fully exposed to market risk. Only the skill of the fund manager might save an investment from considerable losses if markets tumble.

Investors do not know what returns they will receive in 5-6 years time. If the markets go on a Bull Run returns could be substantial but if markets fall the chances are investors will not get all of their capital back. That said, they could keep the money invested for longer in the funds and hope the markets rebound.

The performance of the investment depends on the fund manager and their back room team. Choosing one fund manager over another could see the investment suffer. There is no way of knowing if the fund manager is capable of outperforming the market except by looking at his/her past performance record, which, as we all know, is no guide to future performance.

If the fund manager leaves the company or switches fund, which happens on a regular basis, then it may be necessary to pull out of the fund if the new manager is not considered to be of the same calibre, with potential transactional, tax and performance losses.

The funds use “Ongoing Charge Figure” (OCF) which, on average is between 0.5%-1%, which is taking from the fund, reducing its performance every year. Fees are paid even if the fund makes a loss for the investor.

The big question is should investors take a chance on these new kids on the block, these mutual fund investments?

The answer, of course, is yes. The investor looking to maximise returns and mitigate the inevitable risk in their portfolio considers putting money in both. The structured product for the surety of the defined outcome and the new mutual fund for the human hand on the tiller that can take advantage of opportunities in the market and potentially boost returns. By combining their different styles and options, the investor, or their financial adviser, can create a balanced and diversified portfolio of investments that can be used to good effect in short, medium and long-term investment strategies.
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