PRESENTER: What is the role structured products can play in building a client portfolio? And what do you need to know about the underlying vehicles to use them with confidence? In this Akademia session I’m joined by Davydd Wynne, Portfolio Director and Head of Structured Products at Cazenove Capital, to find out more. And here are the learning outcomes: the main risks in structured products, credit, investment and liquidity; how a structured product is typically put together; and the importance of understanding the small print when it comes to structured products. Well when Davydd Wynne came into the Akademia studio I began my asking him what the main lessons learned have been since the financial crisis of 2008.
Davydd, the structured products market has been around for a long time, but what have we learned from the last decade?
DAVYDD WYNNE: Well a lot has happened to structured products over the last decade. If you go back to the time of the financial crisis, if you remember that structured products are actually only as good as the bank that issues them, there were a number of institutions that were having problems at the time of the financial crisis. What’s happened since then as banks have increasingly found themselves looking to make sure that their capital adequacy ratios are yet more robust, we’re increasingly looking at the payouts from structured products and what they can do, rather than whether a structured product is going to pay at all. It’s been a period of significant change.
PRESENTER: So were the banks 10 years ago using structured products as a way of raising money for themselves rather quickly?
DAVYDD WYNNE: In the way that structured products, fully funded structured products operate is that the funding of the bank is important, and what their treasury is willing to give the structuring department by way of interest is something that is a critical factor in how the structured products are put together, but it’s not the sole purpose of the structured product.
PRESENTER: Now you mentioned it’s 10 years on and everyone’s looking more at payouts, do you think on balance people aren’t thinking enough about the risk, the credit risk?
DAVYDD WYNNE: People should always think about the credit risk involved with a structure product. We may come on to discussions about this later, but first off what is the institution that you’re dealing with in the first instance? Are you happy with them? You’ve got to do your own analysis and make sure that, for instance we link in with credit, our credit department to make sure that everyone’s happy who we use. At the time of the financial crisis we weren’t using Lehman’s for example. So it does matter who you use, as well as the investment outturn that you’re expecting and what sort of liquidity you’re after. In the wider sense, if you’re looking at structured products, they’re not a silver bullet. They’re something that is from our point of view incorporated within a portfolio that is meant to do something distinctive, something different that can be seen as part of a well-diversified portfolio and assisting in delivering the returns that our clients want.
PRESENTER: So it really isn’t, there are actually quite a range of options available and it isn’t a one size fits all solution.
DAVYDD WYNNE: Absolutely right. If you look at structured products themselves, they can do many things against many different assets, and it very much depends on you choosing structured products for the right reason. To my mind the right reason is that you’re thinking right, what is our investment view? What do we think is going to happen in markets? Is there something that we can do normally? Use equities, if equities are the place that you want to be. If there is an opportunity in a structured product excellent, then use that structured product for a client’s portfolio. It’s not like structured products are an end in themselves.
PRESENTER: You mentioned there that structured products aren’t one size fits all, but what are some of the main reasons that you would use structured products for a client?
DAVYDD WYNNE: There are three types of approaches that a structured product can assist with. A structured product can be used for income. You can have auto-calls or kick-outs, they’re very popular. You can have things that are put together that are meant to deliver a higher rate of income. Equally you can have something that’s meant to be participating in the rise of the underlying asset class. You can have participation structures, something that’s designed to advance if the underlying index or reference asset goes up in value, and you’ve got a geared exposure to that. Or a structured product could be a straight put. It could be used for protection. You know, something, or a forward, so that the way that you structure the portfolio is to meet and investment need. What is it that you want to do and is the structured product offering attractive terms at the time?
PRESENTER: Just circling back to the income product, you mentioned auto-calls and kick-outs. Can you just give us a quick definition, are they the same thing, what do they mean?
DAVYDD WYNNE: Absolutely right point to make, in that our industry often has two names for the same thing. So auto-call, kick-out, it is a product that is designed to kick-out if a certain value of the reference index is met, and then it will give you a coupon, or not, if that particular index level isn’t met. And usually the other aspect of it is that it will roll up. So that if the coupon or the return isn’t paid in the first year, nothing happens, it goes forward to the second year. And then if the trigger happens in the second year you get two times the coupon. If nothing happens there you roll onto the third year, or the fifth or sixth year, depending upon how long the product is going. The other side of it though, and it should never be forgotten, is that there is potential capital at risk on the auto-calls. Usually your capital is given a degree of protection, return of capital, so long as the issuer is around and you haven’t gone through a barrier.
Now the barrier can be set at whatever level is deemed appropriate, but if you have gone through that barrier then normally you’re linked into the return of the index. So capital preservation potentially yes, if the index doesn’t go through a certain level. Capital preservation potentially, so long as the issuer is still around to pay it. So there’s the risk side of the equation, but on the upside is that you have a contingent coupon or return. So the potential for a certain payout, but once that payout standard or trigger is met, then if it is met then the payment is made and the product finishes.
PRESENTER: Is that quite tough for planning? If you’ve got a client and you want to provide them with income, and you’re thinking well it might just pay out in one year, it might pay out for the next six, I mean depending on what the underlying index you’re linked to does, that’s pretty, that’s a pretty difficult gig to run for a client isn’t it?
DAVYDD WYNNE: It can be. You can get kick-outs that are taxed to capital gains, not just income. It all depends the way that they’re structured. It is something that people have to factor into their equation. But if you are paying capital gains tax or income tax, it is because you have made a profit. And it’s always a really important thing to remember. If you’re paying tax it’s because you’ve made a profit. But equally sometimes it may be awkward, there may not be offsetting losses in a portfolio depending upon the client’s circumstances. So yes, but ultimately our job is to make a profit.
PRESENTER: And then onto the, you were talking some of the growth structures and participation structures, how careful do you need to be on which index or indices you link to, I mean do they all tend to be on things like the FTSE?
DAVYDD WYNNE: It all depends on who is launching the product. I can only talk about it from the way that we operate, in that we tend to have products at a set reference, major equity indices. That’s the vast majority of what we do. So it really does matter. And it bears repeating in that you always start with your investment view. Just because the equity index is there doesn’t mean that you necessarily have to invest in it. And also think about how the structured product is included within the portfolio. If the portfolio is holding a kick-out, participation structure, whatever it is, you will have other assets that are doing what they’re meant to be doing in the portfolio. Long-only equities that will be going up and down in line broadly with the market, or bonds that will be rising or falling depending upon what’s happened to yields, or your hedge funds or alternative assets, or whatever it is that you’re including within the portfolio. But ultimately if you’ve got a participation structure, you’ve got that because you think that that reference asset is going to be doing something, and you can capitalise on the returns on that through use of a structured product.
PRESENTER: Well that segues neatly in the third part, which is using these for hedging or protection. Could you give us an example of how you might use a structured product as a hedge or a bit of downside protection?
DAVYDD WYNNE: Well, you may just want to put warrant. So you think that the level of the market, currently we’re at about 7,200 on the FTSE, and you think that’s a level that you want to protect against any declines from, so you go out and you buy a, it doesn’t have to be protecting all your exposure, say part of your exposure, through the use of a put warrant. So any fall you’re going to get a benefit from that. Like all these things you have to think how expensive or cheap is it to actually buy that protection? And that comes into the investment consideration, but it is something that you can do.
PRESENTER: But you’re describing there not so much a structured product but a derivative aren’t you?
DAVYDD WYNNE: It’s not a derivative in the sense that it’s an option that you have to post margin for etc., it is a warrant, and therefore in the warrant structure you have no more than the initial capital invested at risk. If it was an option you’d potentially have more.
PRESENTER: And we hear a lot about investors looking for genuinely non-correlated assets. Can you get access to those via structured products?
DAVYDD WYNNE: It depends upon what you’re looking at. For instance you can have something that is targeting steepeners. So in other words you’re thinking that the longer-term yield is going to go up and the short-term yield is going to stay down. And so when all of a sudden that difference happens, you can be in a position to benefit from that. That doesn’t necessarily have any link to the performance of equity indices. Of course it will have link into bond indices, but it’s a way of participating positively from what is a rise in bond yields.
PRESENTER: One more quick question on this, we’re in a period where inflation on the whole has been pretty low over the last few years, over what time periods, even with low inflation, do you start to see the real value of your money get eroded, and how do you factor that in when you’re looking at the real return you’re likely to get off a structured product which might have a term of five years? I think earlier you mentioned things that could even be six or seven years.
DAVYDD WYNNE: Absolutely, in terms of inflation it comes down to establishing your investment view. If you think right, can I do better than cash? That’s pretty important, because otherwise just leave it there. Am I doing to do better than inflation? You want it to, because you want the real value of your asset to grow. So what you’re looking at is those are two thresholds that you really want to be meeting before you then think about whether a structured product or indeed any other investment is worthwhile. So just mentioning the kick-outs or auto-calls, at the minute you can look at potential returns on a single index reference auto-call of about six years getting you close to 10%.
Now that’s if it pays out. I really want to emphasise both the opportunities and the risks. You know, markets may fall such that your capital is at risk. But if you fundamentally think that the FTSE 100 is going to be higher in six years’ time, if it’s a six year product, and you have the potential of a roll up. OK, you get kicked out when it’s met. And you think that inflation is 2½%, and you think that cash levels at ¾%, they’re not attractive. If you think that the FTSE 100 is going to be higher in six years’ time, then you’ve got a good starting point for thinking that that structured product might be worthwhile for inclusion in client portfolios.
PRESENTER: I wanted to move back, you were talking about the risks earlier, we touched on them, but could we run through them in a little bit more detail. So issuer risk or credit risk, how do you go about assessing how risky a financial is? Because I think one lesson from the financial crisis was these organisations are often far more opaque than perhaps people thought who were equity holders in them.
DAVYDD WYNNE: It is really important to draw upon all the resources that you can to establish the credit quality of the people that you’re using. So you will look to all the official ratings, you will look to your own analysis. This is why within our company we spent a lot of time looking at who’s doing what, what quality, whether we’re happy with the particular institutions involved. So spending a lot of time thinking about who you’re going to be using is a really important consideration in structured products.
PRESENTER: How useful are the ratings agencies? I mean they didn’t have a great track record in 2007/08/09.
DAVYDD WYNNE: I’m just going to say that it’s really important that any investment decision that one makes is one’s own. And you draw upon all the strands that you can to inform your decision. And so because ultimately you’re on the hook for the decisions that you make about whether an investment is going to meet the, first off return of capital, then return on capital.
PRESENTER: Rule of thumb, is it the case that the lower credit rating of the institution that’s providing the structured product ultimately, the higher the return it’s offering?
DAVYDD WYNNE: That is a good rule of thumb. There’s many other considerations that come into it, in as much as effectively if you’ve got a lower rate institution, then the funding is going to be more expensive for them. And if it’s more expensive for them, then that should manifest itself in terms of more as it were, more firepower to throw at the potential returns that you can have from a structured product.
PRESENTER: But what are some of the other things that you look at, and if you were a financial adviser is that information that it’s easy to get hold of, or is this proprietary system that you’ve built?
DAVYDD WYNNE: Structured products can be really complex. And the way that they’re included within portfolios means that someone should really know what they’re getting involved in when they’re investing in a structured product. So it is really important to know what you’re doing, because there are many factors in there: who are you using, what’s the credit, what is the underlying payout profile? Because you don’t want to be caught out by finding that you’ve been focusing on the potential returns to the exclusion of looking at the potential risks; it is really important to look at it holistically. And you just do through what you do if you’ve got the resources. We’re on a team, so we’ve got the resources to look at it, and make sure that what you’re doing fits into what you’re trying to do for the overall portfolio.
Once again emphasising the structured product is not just something that determines the return of the whole portfolio; it is an element of it that takes advantage of a particular viewpoint. I mean for instance at the minute you’re looking at gold. Gold has gone up in value. You can have a structured product that’s linked into gold, but with a certain amount of protection in it. So there’s many things that you can do with structured products.
PRESENTER: And we were talking about risks, and you’ve touched there on investment risk, how do you work out what the probabilities or the possibilities are for your investment scenario being wrong, and on the back of that whether it’s a good idea to buy a structured product in the first place?
DAVYDD WYNNE: Absolutely, past performance is no guarantee to the future. For instance if you look at the FTSE 100, and you look at the number of times since the establishment of that particular index, the number of times that it’s gone through the 50% barrier is around 1%. If you look at where the FTSE is currently trading at 7,200 and so say right halve it, 3,600, you are back at the…
PRESENTER: Post 2000 levels.
DAVYDD WYNNE: Well 2009, there or thereabouts, it was a bit lower. And since 2009 you’ve had all the earnings growth, all the awareness of what’s happening in marketplaces and across economies. The banks have rebuilt balance sheets where necessary etc. So a lot has happened since then. So from an investment point of view you have to look at all the factors in it, analyse history, analyse where you are, analyse the valuations, just as it were the bread and butter of investment management, which is looking out and trying to judge the risks. And at the end of the day there is absolutely no certainty.
PRESENTER: I suppose another risk which investors are quite concerned about at the moment is liquidity risk. How does liquidity work in structured products?
DAVYDD WYNNE: For instance the way that we operate, and that’s all I can really talk about, is that with the issuers that we use they commit to providing daily liquidity with a very tight spread on bid and offer. So in normal market conditions there is, so in normal market conditions you can say well what about these stress moments, and do you then find yourself with illiquidity? I’ve been in structured products since before the financial crisis, and during the financial crisis every single institution that we were dealing with was providing liquidity throughout. So that’s one thing. However there are other ways that institutions will launch structured products, such that they make it very clear to you that if you embark on purchasing a structured product there’s very limited liquidity until it actually pays out. So it depends upon who it is who’s looking at the structured products, how they interact with the industry – for instance with us a structured product is embedded within the portfolio as part of diversification, we look to the liquidity of the structured product if needed, and that’s the way that we do it.
PRESENTER: You’ve mentioned using structured products as part of a diversified portfolio, and again this is probably a slightly unfair question because each client is different, but as a rule of thumb what percentage of somebody’s overall portfolio would you have in structured products?
DAVYDD WYNNE: You’re absolutely right to say there’s no one size fits all in this. Well if you look to how the industry, some of the industry say that you can have up to 20-25% in structured products. We tend to have significantly less. We will have under 10% and often under 5% of a client’s, more frequently under 5% of a client’s portfolio in structured products.
PRESENTER: Now I wanted to talk through in a bit more detail those trade-offs between risk and return on a typical structured product. We’ve got a slide coming up here, slide number 4. Talk us through how these payoffs work and the defined protection levels.
DAVYDD WYNNE: In a way what I was just trying to illustrate there is that trade-off between risk and return. Because at one very straightforward level it’s almost simplistic, but sometimes you need to spell it out in that if you are wanting to gain a coupon, or an absolute return or a participation in the marketplace. Say you can get 125% participation in the risk of the marketplace with 100% capital preservation depending on issuer, all the usual caveats that one has to put out there. But then if you then go and put more risk on the table, say capital preservation unless the index falls by 50%, or whatever the level it is that you want to set for the structured product, then maybe you can get 200% participation or higher. So it’s a question, the risk you want to reduce and therefore there’s a good degree of capital preservation. You’re not going to get as much on the upside. Put some more risk on the table, so capital preservation up to a certain level, then you’re participating in at maturity the returns on the underlying index, but you’re getting more.
There are some people who are quite happy with risk. So they say I’m worried about capital preservation. This isn’t the sort of product that we’d naturally look at it, but I’m not worried about capital preservation and therefore I will take the full downside of any market fall, but I want all that to be reflected in a really accelerated exposure to the underlying risk in the marketplace, or an additional coupon or whatever. And actually with structured products, because you can go short, you could actually make a profit from a falling market. So it very much depends upon what risk you want to put on the table as to the potential upside that you’re looking at. So it really is balancing what risk you want to put on the table, and what return you’re anticipating.
PRESENTER: When you talk about an underlying index there, is that just the capital value of the index or is it the total return?
DAVYDD WYNNE: That is the capital value of the index. It’s really important to remember that you don’t get the dividends. So if you’re into a kick-out and it’s reference the FTSE, that is the capital-only value of the FTSE, you don’t get the dividends, also true of the participation structures.
PRESENTER: So when you’re trying to work out whether a, because a participation rate looks good, you mentioned one over 125%, sounds pretty good, how do you work out what participation rate is equivalent to what the total return index would have been? Because that’s what investors are really interested in.
DAVYDD WYNNE: A really good question in the sense that you’ve hit upon what investors want. What we all want, we want it all.
PRESENTER: We want the best of both worlds.
DAVYDD WYNNE: We want all the upside, we want to beat the index, but we don’t want to put any capital at risk. It’s just not going to happen. And so that particular 125% is theoretical but not out of keeping with what I’ve seen in the past. 125% participation means that if you’re up 10% then you’ve made your 12½%. Now that probably isn’t going to make up for the loss of dividend, but it is the sort of thing that on the flipside will see that when the market falls by 30% you’ve got the return of capital. And that is a very important consideration. Equally going back to the construct that we were talking about earlier, where you put a bit of risk on the table, say a 50% fall, you can see a 50% fall in the market and have 300% of the rise.
I’ll go into the maths. If you’ve got a 4% yield on the marketplace, you are going to make, and this is very simple, it doesn’t allow for compounding, you’ve got over a five-year life, you’ve got 20% of dividends that you haven’t received. If you’re getting 300% participation, if the market’s up 10%, you’ve got that 10% of return, plus you’ve got three times that. So you’ve made 30%. So in other words if the marketplace over five years goes up 10% or more, you’re there or thereabouts looking at having compensated for not having the dividend. As I say it’s more complicated than that, because you’ve got reinvestment of the dividends to say what the total return is etc. But again with that particular structure you have had something like 50% capital preservation. So if over the five years, and it does happen, the market has gone sideways, you will underperform the marketplace. But what you have given to a client when you’re investing in that is that you’ve given a good degree of capital preservation.
PRESENTER: Can you just talk through the capital preservation? So let’s assume the FTSE is at 3,000 just to keep it very simple, and you’ve got a barrier, a 50% barrier. How does that work, and during, over five years the index never, it falls but it never gets to 1,500. Do you just get your cash back?
DAVYDD WYNNE: At the end of the day, so it’s fallen and it hasn’t gone through the 50%, you will, so long as the underlying issuer is still solvent and pays out you will get your initial investment back.
PRESENTER: And what happens if the index at some point falls to say 1,000, at the end of the five years is, I don’t know, 2,500? It’s not made its way back but it’s back through that 1,500.
DAVYDD WYNNE: Really good point. It depends upon whether it’s an American or a European barrier. The American barrier is there you are at 3,000, let’s say it’s 50% before you’ve got capital at risk. An American barrier is such that it’s gone from 3,000 through the 1,500, you are now participating in the full change of the underlying index. And therefore if it goes back to 75% or whatever the percentage is of its value, you will get 75p in the pound, or 75 cents in the dollar. If it’s a European 50%, what that does is it doesn’t matter where it’s gone during its life, the pricing of it during its life will matter, but just in terms of final…
PRESENTER: It’s a snapshot on the final day.
DAVYDD WYNNE: Snapshot on the final day, the maturity payout. So long as it hasn’t got, even whether it’s gone through that barrier, so long as on the final day of observation it is not below that 1,500, then you will get your…
PRESENTER: So you must spend a lot of time looking through the small print on all these products.
DAVYDD WYNNE: Yes you do. There’s a lot of small print on the structured products, making sure that what you’re doing is going to be reflected in the terms that are going to be paid out by the issuer.
PRESENTER: We’re talking about, we’ve touched on some of the asset classes, and we’ve talked really about linking structured products to an index or indices, but are there other things they can be linked to as well?
DAVYDD WYNNE: Yes, sometimes people think of structured products as a product in themselves. I think it’s really important to view structured products as a mechanism for gaining access to an investment view. So for instance we’ve mentioned the kick-outs, is there something, fundamentally do you think the FTSE is going to be higher than where it is currently in six years’ time? Yes. At which point is a 10% potential payout or not worth it? If the answer’s yes you’re looking at auto-call or kick-out. If you’re thinking that with all the uncertainties around the corner that actually an investment in gold is going to be worthwhile, you can participate in gold with a degree of capital preservation. Equally if you think that you want to gain exposure to the steepening of the yield curve that I was referring to earlier, you can gain exposure there.
DAVYDD WYNNE: You can actually, within structured products you can gain exposure to funds. You can have what’s called, going to the jargon, Delta 1. So you just link yourself to an underlying fund, and you can get the returns from that fund.
PRESENTER: So are people offering these the whole time, or you for somebody like Cazenove who’s presumably a fairly big buyer in the market, do you go out and see if people will create bespoke product for you?
DAVYDD WYNNE: Bespoke product for us. And that’s one of the things that we can do because we’re of the size that we are, is that we will go into the marketplace and we will ask several issuers what are the terms that they’re going to give us, and so we look and we compare, and we effectively put them into an auction. But we’re also mindful of making sure that we’ve got adequate issuer diversification. You could go with someone who, going back to your earlier question, has got a lower rating and therefore they’re benefiting from very “good” funding rates and therefore they will be offering the best returns each time. No, you have to, well to our mind you have to overlay who it is you’re using, what degree, what quality it is of the issuer and what is the overall returns that they’re talking about.
PRESENTER: Is it a competitive market at the moment?
DAVYDD WYNNE: I think it is yes. We’re finding that people that we’re dealing with are quite keen to do business.
PRESENTER: We’ve got about five minutes left, so I wanted to run through a little bit more how structured products work. And we’ve got a slide here on a simple participation on the S&P 500; can you just talk us through this one?
DAVYDD WYNNE: Both this slide and the slide after, it just gives the idea that what this product is, and as we’ve talked about there are many products out there, but it’s just to give a flavour of one particular product. You come in. You have $100 or $1 to invest. You’re thinking, I think in this particular instance that you’ve put aside $90. Because what you want is something that’s going to give you return of your capital at the end its life. So that $90 that you’ve set aside goes up to $100 at the end of five years, so that’s your capital preservation element. And with the $10 you then use that to, in this instance we’re showing that the underlying issuing bank will be taking a fee of $1. They need to make money from this. And the $9 is left to then invest in the potential upside returns. And for indicative purposes we’ve put it as 125% of any rise in the underlying S&P index.
DAVYDD WYNNE: So the way, what you’ve done is for 100% capital protected structure, caveat issuer being around, you’ve got 90$ over five years will give you your $100, and you’ve got an element that goes into purchasing an option at the bank. And then the bank is contractually obliged to give you the pay out at the end of the life, which is 125% of whatever rise there has been.
PRESENTER: And moving onto that second slide which you referenced there, talk us through, is this a similar structure?
DAVYDD WYNNE: Similar structure, and slightly different numbers, but it illustrates the same point. You’ve got the $1 in what is designed to return capital at the end of the life product. So of that $1 given the current interest rates you need only put 93 cents of that aside. That you can see is going to be growing to $1 at the end of the five years. And then that leaves you with the seven cents to then put towards purchasing an option or several options, multiple options that will give you your participation in the underlying index. And that will depend on market conditions as to what the actual participation rate is. So it’s a graphical illustration of the previous slide.
PRESENTER: So the interest rate that’s available at the time has a big difference on how, what your participation rate is.
DAVYDD WYNNE: Absolutely yes. If you’ve got very high yields, then you’ve got far more to use to purchase the underlying options.
PRESENTER: So I mean you could, and again for illustrative purposes, but it might be your $100, only $80 goes into buying the zero coupon bond, leaving you with $20 to put into the market.
DAVYDD WYNNE: Absolutely right, but in a high yield environment it will have an impact on the pricing of the option. It’s not like the option price will stay, or the options will stay the same price. So it’s multifaceted. Going back to your point of earlier is that there are many factors involved in putting a structured product together.
PRESENTER: How much does equity volatility affect the price of options?
DAVYDD WYNNE: Significant, and you will find with the kick-outs or auto-calls that actually in a higher volatility environment you will normally find that the potential step-up or roll-up level that you can achieve is higher.
PRESENTER: Well sum it up for us Davydd, there’s obviously a lot to consider when you’re thinking about buying a structured product, but why is it worth doing the work?
DAVYDD WYNNE: Structured products are potential opportunities to reflect your investment view. So long as you’ve done the work and you’ve made sure that you’re happy with the issuer, you believe that you’ve got liquidity risk as it were quantified, you can never eliminate it. Structured products tend to be a very good mechanism to allow you to invest in a way that capitalises on an investment opportunity.
PRESENTER: Davydd Wynne, thank you.
DAVYDD WYNNE: Thanks very much.
PRESENTER: In order to consider the viewing of this video as structured learning, you must complete the reflective statement to demonstrate what you’ve learned and its relevance to you. By the end of this session you should be able to understand and to describe the main risks in structured products, particularly credit, investment and liquidity; how a structured product is typically put together; and the importance of understand the small print behind a structured product. Please complete your reflective statement to validate your CPD.