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Have you considered investing in structured products?

A structured product is appealing as it provides exposure to equity markets, but also provides partial or full capital protection if these markets fall.

An investment product innovation that has gained increased traction over the last few years as a supplement to traditional retail unit trusts and share portfolios is an investment class broadly known as structured products. Structured products are pre-packaged, fixed-term investments that offer retail investors easy access to local and offshore equity markets but with the added benefit of a pre-defined and pre-packaged risk and return profile.

Why would anyone want to invest in a structured product? Let’s use an example. Markets have rebounded strongly post their lows in March 2020 and some markets are now trading at expensive levels i.e. the S&P 500 (the US stock market) and the Nasdaq (a proxy for technology companies). The US stock market now makes up roughly 65% of world stock markets as measured by market capitalisation and has become outsized relative to other markets.

The US stock market has been resilient over time and no investor should ignore this market. However, at current expensive levels, it may just be a different story going forward. Investors could therefore remain invested in these equity markets but it’s just a matter of managing the downside risk if these markets experience a material drawdown.

A structured product is appealing as it provides exposure to such equity markets, but also provides partial or full capital protection if these markets fall. Essentially, investors receive exposure to equities and the upside of such but at a predefined reduced level of risk or loss of capital.

More detail about structured products…

The term of the structured product usually ranges between three and a half to five years. Hence, from a tax perspective, capital gains tax would apply unless the investor surrenders earlier than three and a half years, in which case it may be treated as income and taxed as such.

The issuer of the structured product utilises asset classes like equities, bonds and derivatives, to structure the specific performance and risk profile for the investor also called the pay-off profile. The pay-off profile refers to the balance between downside protection (capital protection) and upside participation (level of participation in the investment growth).

Like other investments, structured products can also be classified according to a specific risk profile. Cautious investors may opt for a higher level of capital protection with a corresponding lower eventual investment return, while more aggressive investors might be comfortable with less capital protection and a higher level of growth participation – they may even wish to leverage their upside to yield outsized returns if the market provides a certain result.

Some structured products are offered in offshore currency terms and are linked to offshore markets like the S&P500, the FTSE100 or the Eurostoxx50. Accessing these offshore structured products requires a physical transfer of funds offshore into offshore currency which is then invested into the structured product. Other offshore structured products may be rand-based albeit that the payoff profile is based on an offshore market as well as currency appreciation or depreciation. These offshore structured products will finally settle in rand terms and will not require a physical purchasing of offshore currencies.

Wrappers

Structured products can be invested through vehicles such as sinking funds or endowments which provide worthwhile tax and estate duty benefits, such as:

  • Investment income and capital gains being paid within the investment, on behalf of the investor, at a capped income tax rate of 30% and capital gains tax (CGT) of 12% respectively.
  • Beneficiary nominations circumvent the complications of potential offshore inheritance tax and executors’ fees, although the value will still form part of the investor’s South African estate for estate duty purposes.
  • In a life wrapper, the value is protected from creditors after the investment’s first three years have passed. 

Potential risks

The risks involved with investing in a structured product can be summarised as follows:

  • Counterparty / Credit risk – it references the ability of the financial institution, providing the guarantee of capital protection or enhanced return, of actually making the required promise upon the maturity of the structured product.
  • Liquidity risk – structured products are designed for an investment period of between three and a half and five years. To take full advantage of all the promises the investor needs to stay invested to maturity. However, liquidity is an option in that the investor can withdraw funds prior to maturity, but it must be noted that this action will strip away any protection inherent in the product which could result in capital losses, should the underlying assets be priced at a loss. There may also be a bid-offer spread i.e. a further cost to terminate the structured product.
  • Structured products do not pay any dividends. There is some compensation for this in the gearing offered, but there is no yield. It should therefore be noted that if the structured product references any market, the returns gained are only of capital nature and not income or dividends.

How does a structured product work in practice?

Taking all of the above into consideration, let’s analyse an example as to how an investment product may be structured.

The following is merely an example of how various facets may be combined to create a unique structured product. Any of these benefits or outcomes may be combined in different ways (such as the level of capital protection, the possibility of capped or uncapped investment growth, or guaranteed minimum investment returns), but for the purpose of this example, we will focus on a specific set and combination.

Certain products referred to as an ‘Auto Call’, may mature either in year three, four or five, if the underlying asset shows a positive return at that point in time. But the product we are going to look at is designed to run for a full five-year term.

Another concept to clarify is ‘Hard’ and ‘Soft’ capital protection. The former refers to 100% capital protection, regardless of how far the underlying asset has fallen in value over the investment period. The latter then provides 100% capital protection, but only if the index does not lose more than a specific percentage in value (e.g. 50%), after which the investor will take part in the full loss. For our example, we will focus on ‘Hard’ capital protection.

The following three tables and accompanying line graphs illustrate three different outcome scenarios:

  • negative to 0% investment return;
  • 0% to 70% investment return; and
  • 70%+ investment return. 

Scenario 1

INDEX RETURN OVER 5 YEARS BENEFIT RETURN RECEIVED AT MATURITY
Negative to 0% Capital protection / Minimum return 100% of the investment amount

(“Hard” Capital protection)

If the index is negative or returns 0% over the investment period, the investor will receive 100% of the initial invested capital back. This is referred to as “Hard” Capital protection, where, no matter how far negative the underlying asset ends, the investor’s full capital is guaranteed.

Scenario 2

INDEX RETURN OVER 5 YEARS BENEFIT RETURN RECEIVED AT MATURITY
0% to 70% Enhanced return 170% of the investment amount

If the index ends the investment term positive, up to 70% above the initial investment value, the investor will receive 100% of the initial capital back, plus a cumulative 70% investment return. For example, whether the index only returns 1% or whether it returns 65%, the investor will receive the full 70% return, over and above the 100% initial capital also returned.

Scenario 3

INDEX RETURN OVER 5 YEARS BENEFIT RETURN RECEIVED AT MATURITY
70% + Uncapped upside 170% of investment amount plus 100% of return above the 70%

If the index ends the investment term above 170% of the initial investment value, the investor will receive 100% of the initial capital back, plus 100% of the actual investment return. For example, if the index ends the term on 190% of the initial investment value, the investor will receive the initial capital back, plus the full 90% investment return.

Costs and fees

Costs and fees are usually fully priced into the structured product. If the structured product offers you, for example, a possible cumulative return of 45% this is expressed net of all fees and based on the initial investment amount. Any costs will typically be paid as an upfront fee to the service provider concerned, usually at the start of the investment term. However, as mentioned, these fees are built into the product and will not affect the outcome of your investment or reduce the initial investment value on which ultimate returns are determined. 

Conclusion

Structured products are designed to form part of a well-balanced and diversified investment portfolio. Such products can specifically add value where low investment returns are expected (and the investor can leverage the performance to produce a high return) or where investment markets are expensive or volatile – as we have been experiencing over the past five years.

During uncertain times capital protection of any kind is a sought-after benefit. This coupled with the possibility of an enhanced investment return is an attractive combination.

Each year various insurers and investment companies issue numerous local and offshore structured products, each with its own underlying characteristics. Our investment research team analyses these structured products and pro-actively advises our clients to consider such if we find such is suitable to their risk profile and performance objectives.

For further detailed information on any structured product, please contact your GraySwan financial advisor.

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