Structured Products vs. Absolute return
30 September 2016
A fortuitously timed web debate I attended just prior to the Brexit referendum covered how investors could protect themselves in times of volatile markets, and whether absolute funds or structured products would be most effective. (see link here: http://www.moneymarketing.co.uk/mm-wired-structured-products-uncertain-markets/).
Both structured products and absolute return funds are generally aimed at investors requiring an income or some certainty around their return. Neither give any strict guarantees (unless you’re willing to pay extra for them!). Here we aim to give an overview of the relative strengths and weakness of each approach.
Absolute return funds as a sector can be a very mixed bag of investment types and strategies. There are various long/short, long only, and ‘macro’ strategies as well as different asset classes involved. The most sophisticated and largest funds will employ a team of people making investments across roughly 30 investment strategies at a time. This may mean the funds require an extra amount of time to be researched properly and understand the strategies involved.
The benefit of this is a level of diversification not possible in individual investments held by a client. In addition, all absolute return funds must publish a time horizon over which they aim to make a positive return. This time horizon helps give some idea of the level of risk and appropriate length of time that an investor should remain in a fund, as well as provide a performance benchmark.
Meanwhile, structured products on the surface are more easily understood. Usually they will be based on an underlying index, such as the FTSE 100 or S&P500 and then a series of possible outcome presented that will pay an income or return given some risk to the underlying capital. However, these possible outcomes are created via the use of options, which can greatly increase the structured product’s complexity. In addition, the use of options means that despite being based on a simple underlying index, benchmarking becomes impossible.
One final but important factor for consideration is whether or not the structured product pays out for dividends of the underlying index. This is important as dividends can make up a significant amount of the expected return received by an investor. For example, the current UK FTSE100 forward dividend yield is 3.74%.
Most absolute return funds fall under a UCITS or NURS structure, so have regulatory requirements to publish fees and report returns against a benchmark. Fees are generally known in advance, although there are a handful of exceptions to this where some funds employ a performance related fee (PRF), but this too should be made clear in the fund literature (as required by legislation of UCITS and NURS structures).
With structured products, fees are usually embedded in the options for each product and as such it is virtually impossible to compare costs between different products and providers. These structured products usually fall outside UCITS and NURS so the regulatory requirement to publish costs is lower.
Absolute Return funds can be based on a variety of strategies. There are some in the sector which are relatively simplistic, for example long/short equity stock pickers, but the larger absolute return funds run by well-established firms are very well diversified across many strategies. While the overall level of risk may be selected by the client using the time horizon of the fund as a guide, the choice of where to add risk and level of market diversification rests with the fund manager.
Structured products are usually based on a single underlying index or aim to control risk via the use of options. The downside to this approach is the underlying index may be relatively undiversified (e.g. a pure equity index), and the use and selection of the options is left to the investor or adviser to decide upon. In this sense these products present a less diversified final product to investors.
Another difficult point for advisers is that an investor looking for protection in a downturn will generally be low risk and have low tolerance for falls in their investment or income level. Unfortunately structured products tend to be rated as medium to high risk due to their level of complexity and high impact of options on the level of return.
Investing in an absolute return fund involves the same process as investing in any NURS or UCITS fund. That is, the investor will need to invest via a fund platform or other tax wrapper. In the vast majority of cases, any investment will be protected by the Financial Services Compensation Scheme (FSCS).
Structured products don’t fall under a set structure such as UCITS or NURS, and will have a higher level of counterparty risk as the embedded options will often have just one counterparty. For example, in the 2008 financial crisis some investors were unaware that they were exposed to losses when Lehman Brothers defaulted as they were unaware Lehman was the counterparty used for options in their structured product. Some structured products can be covered if they are within a recognised scheme by the FSCS, for example if they are a deposit or held within an ISA. Overall, investors need to be more careful with structured products as they carry higher counterparty risk and not all are covered by the FSCS.