Over the years, clients have sought advice about structured products, especially at times when the markets are in turmoil or when they are concerned about downside risk in equities markets. Such products, also known as structured notes, are vehicles that offer a guaranteed return on investment, within certain parameters.
These products are generally packaged by the large banks or life assurers and marketed as a way for risk-averse investors to grow their capital in a protected investment. This sounds great in theory, but investors should be aware of the downside of these instruments. There are no free lunches in the investment industry, and in this case, the bill usually takes the form of a thick layer of embedded fees.
Here are a few reasons we do not generally recommend structured products for our clients, unless under exceptional circumstances:
- Structured products often reference stock market price indices, which exclude dividend payments. This means that you will get lower returns than you would from direct exposure to the underlying index.
- While many products reference offshore indices, returns may be paid in rand. The product will often not factor the movement of the rand into the final payout. Thus, structured funds may not be the most effective way to protect yourself from currency risk.
- Structured products won’t generally completely shield you from downside risk. They will often include a clause to the effect that you will face the full downside if the reference index falls beyond a certain level – for example, 30%.
- Products may average out the reference index in the last number of days prior to maturity to calculate the payout. This can smooth out some of the volatility. However, it can also significantly reduce your potential upside. A recent example would be the month of November 2020, the best month on the S&P for over 30 years. The exceptional return of 10.95% for the month was on the back of negative returns for September and October. Under a typical product, the reference index may have been averaged out over, say, 30 days, and this would have severely dampened investor returns.
- Some products are tied to credit from a third-party, which is not necessarily the issuer. This means that in certain instances, there could be dual counterparty risk to the end-investor should either the issuer of the note or the third-party have a credit event.
- Our research into a range of structured products finds mediocre historical performance across most. The more exotic the product, the higher the embedded fees will typically be and the less likely the investor is to benefit, on average.
- Structured products may offer embedded tax advantages, for example, when the issuer has an assessed loss. However, there will typically be a charge for these tax benefits, thereby reducing the net performance accruing to the investor.
- In most cases, you will need to lock your money into the product for a set timeframe to validate the guarantee, with limited liquidity. You will usually need to pay a penalty for a full and early withdrawal or find a willing buyer.
- It is difficult to take a long-term view of specific indices, especially when they are selected based on regional themes, for example, an ‘Asia Seas Basket’. Structured products inhibit the flexibility to rebalance the portfolio based on changing market circumstances during the term of the contract.
In our view, an investor who consistently uses structured products over time will generally come out with lower returns than they could get from looking at other non-equity instruments or products with similar risk profiles. Similarly, the returns on these products are unlikely to better the returns from direct, unhedged exposure to indices, as equity markets have empirically moved up over the long-term. As an alternative to protecting portfolios from downside risk in exceptional circumstances, we prefer the use of shorter-term hedging strategies in our proprietary Funds.
The high levels of embedded fees mean that structured products are not ideal vehicles for most long-term investment portfolios. In addition, we recommend considering only simple and transparent structured products when the need arises. We invite you to contact us if you’re considering investing in a structured product, in order that we can evaluate the specific offering and confirm whether it represents the best way to achieve your investment goals.