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A tale of two defensive structures

Stephanie McClarence, - 18/03/2015

Whether considered as a fundamental component of a portfolio or as a standalone element, we believe that a blend of structured products, providing balanced counterparty exposure, can offer significant added value and could even work as a good starting point for an investor.

There are a number of products currently available that could complement each other in a portfolio and in this article we will look at two such growth products that offer enhanced or, 'geared participation', in the growth of the FTSE 100 and have a lot of similarities.

Firstly, the Morgan Stanley FTSE Defensive Supertracker Plan 9 offers a potential growth equal to 3.2 times the rise of the FTSE 100 from 90% of the initial index level, with the maximum gain capped at 64%. This means that, even if the FTSE 100 is back at its initial level at maturity, the return investors will receive will be 32% being 3.2 times the difference between 90% of the initial index level and the final index level. If the final index level is 10% or more above the initial index level, investors will receive the full 64% gain.

The investment capital is of course put at risk for the potential rewards however, the 'barrier' for this investments dictates that no loss should arise from market movements unless the FTSE, at the end of the six-year term, is 50% or more below the initial level.

Next, we have the Societe Generale UK Defensive Growth Plan (UK Four). This, too, offers growth linked to the rise in the FTSE 100 from 90% of the initial index level but at an increased participation rate of 5 times rather 3.2 times albeit with the maximum gain capped at 60% rather than 64%. Therefore, if the FTSE is at the same level at maturity as when the plan commenced the investment will produce a 50% gain and the index only needs to be 2% higher to produce the full 60% gain. It should be noted however, that as part of the trade-off the 'barrier' for this investment protects against loss from the index being down by not more than 40% at maturity, rather than the 50% barrier for the Morgan Stanley plan. What this means is that if, at the end of the six years the FTSE is down by 45% the Societe Generale plan will give rise to a 45% loss but the Morgan Stanley plan will return the original capital.

Another important distinction between the two plans relates to counterparty risk. All such investments are effectively loans to banks and if the bank defaults and cannot meet their contractual obligations a significant or, in extreme circumstances, a total, loss could arise. The Morgan Stanley plan is wholly reliant upon the bank itself meeting its obligations, whereas the terms of Societe Generale’s plan have been enhanced by adding further exposure to four other UK institutions (Aviva, Barclays Bank plc, Lloyds Bank plc and The Royal Bank of Scotland plc). In the event of the failure of Societe Generale the plan’s assets are collateralised to the extent that whilst an enforced early maturity is likely to occur and this could result in a loss, it should never be a total loss. If however, one of the four UK institutions should fail, up to 25% of the investment will be exposed and in extreme circumstances all of that portion could be lost. If all four institutions fail then a total loss is highly likely but in these circumstances it should be acknowledged that all investments everywhere may have been decimated.

In our opinion, the differences between the plans do not make one particularly better than the other and it is of course hoped that markets will be positive to the extent that the only ultimate difference is that one returns 60% against the other returning 64% but of course the acceptance of risk does not always transpire in the best possible outcome.

As ever, diversification can help mitigate risk and by blending the plans together, not only do we spread counterparty risk further, reduce the potential impact of the different participation rates and blend the barriers, caps and participation rates, we also end up with diversified observation dates because the Societe General plan observes the FTSE on 10th April 2015 and again on 12th April 2021 whereas the Morgan Stanley plan observes on the 17th April 2015 and 19th April 2021.

For smaller investments, the extent to which the products could be blended is possibly dictated by the minimum investment amounts being £10,000 for the Societe Generale plan and £3,000 for the Morgan Stanley offering and for say a £13,000 total investment this does not necessarily dictate a bad mix.

The chart below shows the returns for both products individually in different market conditions and the effect of blending them together equally, assuming equivalent FTSE index movements and also shows the anticipated returns that would be achieved at the end of six years by a FTSE tracker fund after accounting for an additional 3% per annum return for dividends net of charges.

*assuming linear growth and 3% per annum for dividends net charges.

Obviously, by blending a tracker with the structured products you can change the payoff profile further and potentially create a portfolio containing the best of both worlds.

It should be acknowledged that whilst the defined returns are only applicable at maturity, both products can be sold mid-term and it is not beyond the realms of possibility that best value could be achieved by selling out prior to the final maturity date albeit this should not be done without considering all factors and perhaps after obtaining the requisite advice.

While we appreciate that many other investments could outperform a portfolio such as this in certain market conditions there are clearly circumstances when these products will produce very good returns by comparison to alternatives and as such, I’m sure you can see why we believe they may make an attractive complement to other investments.

Portfolios of structured products can be monitored via our dedicated portfolio management tool, SP-Perspective which has been designed to provide you with an overview of the structured products your clients hold and includes the most recent surrender prices for most providers.

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