Until fairly recently South African investors were limited in their choice of investment products. Banks and asset managers offered a very narrow range of vehicles for people to grow their wealth.
That has however changed significantly with the introduction of the likes of exchange-traded products and hedge funds. In the last few years, there has also been significant innovation in the space of structured products.
These provide investors with easy access to products that establish a known pay-off profile at the start of the investment. Through the use of carefully structured derivatives they usually provide some level of gearing to accelerate returns on the upside, while also offering some level of capital protection.
The demand for these products has been particularly strong in the last 18 months in the face of volatile markets. Investors who may not ordinarily have the risk appetite to get into equities are purchasing structured products because they offer that exposure but with downside protection.
Investing with a parachute
“It’s like a parachute,” says Dion Desaunois the managing director of Pegasus Wealth Management. “You can have exposure to equity indices, but then your capital is protected if something falls out of the sky like the 2008 crisis.”
This is a particularly compelling option for investors who have already built up a sizeable asset base and are looking for different drivers of risk and return within their portfolios.
“Structured products aren’t for every client, but for those who already have significant amounts invested in vanilla products, we like the diversification they offer,” says Melissa Dyer, head of the advisory business at Harbour Wealth. “Every fund manager is telling the same story at the moment, which is that we should expect lower returns for longer. With that outlook, if we get an element of gearing and throw in a bit of protection as well, that is a very good offering to blend into a portfolio.”
Anyone investing in structured products does however need to understand that they will be exposed to the credit risk of the issuer, and this needs to be managed.
15% to 20% of total portfolio exposure
“Different clients have different needs, but we might expose a client up to 15% or 20% in an overall portfolio,” says Desaunois. “But you have to manage the risk and ensure that you aren’t overly exposed to just one product or just one issuer.”
Investors also have to accept that they will only see the stated return from a structured product if they hold it for the full term, which is usually three to five years.
“You do have to accept that you are giving up access to your money,” says Dyer. “But when you are doing risk and investment planning, you are always going to be looking at growth over five years plus anyway.”
One of the most appealing factors of structured products is that they are mostly designed around indices in developed markets. South African investors tend to have a lot of exposure to local assets, and more of them are coming to understand the risks this represents.
International exposure with fewer risks
They are therefore looking for greater offshore exposure. Structured products are a compelling way to do this, because they also offer protection from some of the risks associated with investing in international assets.
“Structured products offer easy access to offshore markets and hard currencies,” says Kenric Owen, head of structured products at Investec. “Our clients enjoy investing with a pre-defined payoff that has a high probability of meeting their targeted return with the benefit of capital protection as well.”
Investec’s S&P 500 Rand Autocall, which is currently open for investment, is an excellent example of the benefits of these products. It gives investors the opportunity to earn a return of 70% in rands over five years, or 14% per annum, if the S&P 500 index is up even a single point over that time. It also offers full capital protection if the index falls, provided it is not down by more than 40% at the end of the term.
The product also offers an “Autocall” redemption, which allows the product to mature early if the index closes higher at any automatic redemption date – paying 42% after three, 56% after four or 70% after five years respectively.
“If the market is up as little as one index point you will get your money back plus 14% per annum at those dates,” Owen explains. “If it doesn’t call, it will roll over to the following year. We see that as quite compelling. And if you compare this with the expected return of other asset classes like fixed income or preference share returns, it is certainly attractive”.
A look at the performance of the top retail unit trusts that returned above 14% per annum over the last 3 years reveals that only 26 out of 276, or 9.42% beat this marker. The S&P 500 and JSE Top40 total return indices yielded 13.8% and 11.32% over the period respectively*.
What makes a structured product an appealing investment is its flexibility. There are many forms available, offering something different for investors across the spectrum. Improved accessibility, increased transparency, and market-specific attractiveness of these products now means that South African investors have choice. Whether that is a good or bad thing depends on who you ask.
*Data measured from 24/6/13-24/6/16 (last 3 years) source, Morningstar