I first started writing critical articles about structured products in the early 1990s and warned of the possibility of the precipice bond disaster. Like many adviser firms, ours has very rarely recommended any specialist products in the past but, periodically, I revisit the SP ghetto to see what the geeks are up to just in case there are signs of intelligent life.
The problem with SPs from the outset has been the confusion of risk and probabilities. As is often the case, Warren Buffett has put it better than I can. “A small chance of distress or disgrace cannot be offset by a large chance of extra returns.”
Why? SP devotees will actuarialise you with statistics showing low probabilities of loss but this is not the important issue as far as the biggest group of possible investors are concerned, namely those with the highest aversion to risk. Here, the real issue is risk capacity, the individual’s ability to with-stand losses. This is not probabilistic – it is a matter of fact and of the adviser’s realistic interpretation of their circumstances and needs.
Take the classic little old lady with limited capital. If she buys a capital-at-risk product and it goes wrong, what are the consequences? What is the potential impact on her standard of living?
You cannot rely on the small probabilities of a loss-causing event based on the historical record. The credit crunch showed how wrong those probabilistic assessments can be. The point is that she cannot afford loss. It is therefore wrong to incur the possibility of loss, even if the prob-ability appears very small (probabilities in investment never “are”, they only appear and then change).
So I find it depressing that there has been a big revival in CAR products, which I fear are being sold by some IFAs (although they never seem keen to own up to this).
A second drawback that even the providers do not seem to understand is reinvestment risk. If you buy an income-generating SP, at the end of the term, you have to reinvest, with no idea what rate of return you will then be able to obtain. So the investor is exposed to a risk they have not thought about and would not really under-stand if they did. Try the thought experiment of a series of three five-year income-generating SPs compared with a 15-year investment in equity income funds. Providers will not be keen to show you the numbers.
So much for the old negatives. But the geeks have made improvements. Listing SPs so that they can be traded enables discretionary fund managers to churn these plans and generate even more commission. Kickout plans take to the extreme the play-the-odds gambles that could be sold at racecourses and appeal to the intuitive (and usually wrong) assessments of odds by naïve punters (doesn’t the bookie usually win?)
The only genuinely interesting development I have come across is the creation of SPs in the form of ongoing funds, such as those from SIP Nordic/ RBS, Privalto/BNP Paribas and Barclays. These provide an alternative form of absolute return investing that make an interesting comparison with, and may well complement, other absolute return funds. But this is grown-up investment, as opposed to SPs, which are what banks across Europe sell in huge quantities to their woolly customers.
Chris Gilchrist is director of Churchill Investments and editor of The IRS Report