OPINION: Don't write off structured products

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You may think that structured products are heading the way of the dodo, but smart advisers are realising that they have a major role to play in a client's investment portfolio, argues Instreet MD George Lucas.

Structured products often get a bad press, even when they have performed in line with expectations. But it’s not deserved. They can play a significant role in an investment portfolio, and smart investors –and their advisers – who understand the risks appreciate this.

The problem is that structured products are seen in isolation – and critiqued as a stand-alone investment solution. This is wrong. What good advisers do is devise a client’s total investment strategy and then work backwards to see if a structured product can be part of it.

This approach takes time and effort, but, as the survey commissioned by the SMSF Professionals’ Association of Australia (SPAA) and the index fund manager Vanguard recently highlighted, investors are prepared to pay for good, strategic advice. In fact, more and more they expect their advisor to offer sophisticated strategies to justify their fees – and advisors who fail to do so could find their client base dwindling.

So what does this entail for advisors, and how do structured products play a role?

It means engaging with your clients to determine their investment goals? What is their risk profile? More importantly, how much risk do they want to assume? Do they need to generate yield?  The list is almost endless.

But it is only by engaging in this exercise can the adviser develop the appropriate strategy with all the known risks factored in. Then – and only then – should advisors consider recommending these products as part of an overall strategy.

But before looking at their role in more detail, a general comment about this market is warranted.  The relative decline in the Australian structured product market is being cited as evidence that these instruments are headed the way of the dodo bird.

After all, in the six months to 30 June 2012, only 74 new and existing products were on offer raising inflows of $685m, a pale imitation compared with six months to 30 June 2011 when 157 products generated estimated inflows of $1,474m.

The reasons are obvious; investors are risk averse and leveraging and growth products are on the nose. But so are inflows into equities and growth-orientated managed funds; cash is king in the current environment. But the doomsayers should take a deep breath – and have look at what has happened in the UK where these products, despite a similar bad press post the GFC, are attracting pounds as investors react to low interest rates and volatile markets and engage their clients using structured products.

Based on the UK experience, there’s no reason to believe they will lose their ongoing appeal in our market.

So assuming an investor’s risk profile and investment strategy justifies a structured product, how can it work inside a balanced portfolio?

Let’s take, for example, an SMSF with $1m in funds under management – the average SMSF balance according to the tax office – and an adviser and trustee who is 'bullish' on the equity market.

For trustees of this SMSF, a structured product offers the opportunity to capture the potential for equity market upside for an outlay of the interest payment (less any coupons received). This, for example, in a $1m portfolio could be around $15,700 for the equivalent of $100,000 exposure (10% of the portfolio) – and only 1.57% of the fund’s capital. Here’s how it could work for a product using the S&P/ASX 200 index.

The fund invests $7,900 upfront, which is the interest to gain $100,000 exposure to the S&P/ASX 200 index over three years. In the following two years the fund has to pay $3,900 each year ($7,900 interest less a $4000 coupon payment made to the investor each year), for a total payment of $15,700 over the three years. For the above portfolio this would increase the exposure to the S&P/ASX200 by 10% for a known downside outcome.

During the same three-year period the $1m in defensive assets could have generated a yield of $60,000 a year or $180,000 over the three-year period – and this $180,000 more than pays for the exposure to the S&P/ASX 200.

There is a downside, but it’s manageable while offering trustees the opportunity to tap into the equity markets’ potential upside without significantly altering the fund’s asset allocation and preserving the capital, and most of the income, that funds their immediate needs.

I would argue that as part of an overall strategy, either defensive or growth-orientated structured products can assist in achieving the trustee’s goals.