The industry has an obligation to take a fresh look at this space, but due diligence remains critical
Last month, I suggested there may be a real opportunity for structured product providers to compete in the absolute return space if advisers could be persuaded to be open-minded enough to embrace well-constructed solutions.
It does seem some advisers’ minds are firmly closed on this issue. Indeed, since my article, I have been deemed an “idiot” by at least one adviser, while others scoffed at my apparent advocacy of them as a panacea for fund management ills.
One typically anti-everything (bar trackers) commentator even evoked the spirit of Pete Seeger, wailing “when will they ever learn?”.
Let’s first dispense with the common tarring of structured products as toxic, referencing their prevalence in the commission-bearing offshore market or the precipice bond debacle.
These protestations are irrelevant. In the UK, commissions cannot be incorporated into the pricing model.
As for precipice bonds, much of that furore was down to misselling – mostly by a small number of greedy retail banks desperately trying to raise alternative capital, and who were punished accordingly.
My “well-constructed” definition adheres to the FCA’s recommendations in TR15/2, the thematic review of structured products published in 2015.
The products should provide clear economic value to a defined target market of customers, via pay-off profiles that are attractive but not extreme, having been stress-tested accordingly. Their objectives must be fair and clearly articulated, with marketing material allowing advisers to ensure any product is suitable for their clients, who in turn match the target market.
In other words, the definition applies to structured products in exactly the same way as it does with any other financial product.
Solutions properly designed by the strongest providers for retail investors but distributed by advisers are almost, by definition, unlikely to become future industry bêtes noires.
Structured products should be seriously considered by diligent advisers, and adequate research performed, rather than a lazy or stereotypical dismissal. As with any intermediated investment opportunity, individual client suitability is not assessed by the provider but by the adviser.
Since a structured product is no more than a contract between the investor and the provider to fulfil an objective if a certain set of criteria are met (or indeed avoided), it is, in essence, a bond – the stronger the issuer, the less likely a default.
Bond issuers price in perceived default risk via higher coupons. Pay-offs in structured products may not similarly reflect counterparty risk, so this is the most fundamental risk that needs to be assessed by the intermediary.
I suspect a significant number of advisers are rather less confident assessing counterparty risk, or the risk/return profile and “value for money”, of a structured product than of a fund or portfolio.
Banks’ credit ratings might be an obvious starting point, but the regulator is quite specific that, in isolation, this is insufficient data upon which to assess counterparty quality, as became apparent in the financial crisis of 2008.
Credit default swaps are an additional important indicator of counterparty risk. Effectively an insurance contract covering the potential non-payment of a debt, the buyer of a credit default swap receives credit protection, while the seller guarantees the creditworthiness of the issuer. The changing spread on the swap (i.e. its price) reflects the perceived creditworthiness of the issuer in real time.
Assessment of risk requires both backward and forward-looking metrics, as per fund research.
Credit ratings are forward-looking views, balance sheet fundamentals are historical “facts” as at the date of the last set of published reports and accounts, while past volatility of CDS or share price are backward-looking indicators.
Understanding of the relative importance of CDS spreads, Tier 1 capital ratios and other bank balance sheet fundamentals are explicit regulatory requirements of advisers considering structured products.
However, while advisers might use FE or Morningstar data and analysis tools to produce “scorecards” by which to screen funds on a quantitative basis, they may have less knowledge about sources of information and data analysis on structured products and providers. The FT Banker Database identifies approximately 3,400 banks globally. A useful rule of thumb might be to restrict the due diligence process to global systemically important banks or, as a minimum, domestic systemically important banks.
As the name suggests, GSIBs are the more important banking groups globally and, as a result, are subject to higher supervisory expectations on risk management, governance and capital adequacy requirements.
The latter includes higher Tier 1 capital ratios, along with further incoming rules regarding total loss absorbency capacity. But this data does not easily come to hand.
As for assessment of a product’s “economic value”, there are a variety of less familiar metrics that cover return potential; e.g. expected return to value at risk best 10 per cent ratio – the higher the number, the greater the likelihood the headline return will be achieved and lower the risk of the investor misinterpreting potential returns.
Businesses like Tempo Structured Products and Levendi Capital provide comprehensive scorecards, respectively for issuer and counterparty risk, and product risk/return analysis. Tempo offers comprehensive training modules within its adviser academy, and is the first structured product provider to be both a corporate member of the Plain English Campaign and to have all its marketing material Crystal Mark approved.
The industry is increasingly challenged to provide solutions that are economically appealing to retail investors. Structured product providers whose solutions are aligned to customer and regulator expectations can be an important contributor to investor wellbeing.
But that depends on advisers accepting they have an obligation to take a fresh look at today’s structured products landscape and investigate those opportunities diligently.
Graham Bentley is managing director of gbi2