Tracker + Products
The new world of investing – Investment 2.0 – hasn’t only meant a huge growth in the conventional tracker space and ETFs. It’s also prompted the furious growth of a related but separate area of investment – the structured product or what we like to call Tracker Plus products.
Many analysts would react with horror if you grouped together such disparate investment products as ETFs, and structured product based certificates but the reality is that they are, in fact, quite closely related.
Both ETFs and structured products originated in the complex world of derivatives trading. In this slightly opaque business the parcelling out of risk, reward and ownership into different products is routine. You might for instance buy a futures contract on gold but never see the gold or even own the gold on paper. You’d simply buy an option that may or may not give ownership of something at a later date.
Likewise with ETFs – you own a piece of paper that ‘represents’ or ‘approximates’ to a parcel of shares – as well as tracker plus products. With the latter you indisputably buy into a product that tracks an index but you might ALSO get an element of capital protection as well as some leveraged upside.
As you’ll rapidly discover these ‘extra’ benefits come at a cost and not all structured products are created equal. This ‘patchy’ market means that you have to research the ‘tracker’ deal on offer, scrutinise the terms and understand the concept. Many, if not most structured products offered on the high street are rubbish – sophisticated investors wouldn’t touch most guaranteed equity bonds through IFAs for instance. But there’s a growing number of compelling Tracker Plus products that in fact hugely popular with a specialised market of smaller institutional investors and knowledgeable private investors.
Banish Risk and Lock in those returns !
Structured products have been around in the
To understand why these precipice bonds eventually became a cause celebre within the world of ‘low’ finance, one first has to understand what a structured product is.
Uncertainty and risk is the great peril of modern investing, but what would happen if a bank could offer to take some of that risk away from you, in return for some kind of guaranteed payout ?
How about the following deal…..?
1. You give me 100p for each share in a closed end fund
2. I, in return, offer you a guaranteed payout of 100p in six years time
3. I also offer you 180% of the upside of the chosen index – the index you’re tracking.
Great deal ? Well this is a real structured product currently available from Merrill Lynch’s specialist structured products investment trust team – the fund is called the European Capital Protected II Shares. It exhibits most of the key characteristics of a structured product
· It tracks an index – in this case the DJ EuroSTOXX 50 index
· It gears up that tracking. In this case it offers 180% of the returns of that index
· The final index level is calculated using a fairly standard industry averaging formula. In the case of this trust it’s as follows – “The final reference point of the Index will be the average of the closing value of the Index taken on each of the 13 Monthly Index Averaging Dates (expected to be either the 15th ,16th or 17th day of each month from (and including) December 2011 to (and including) December 2012)”.
· It offers a fixed term – in this case 6 years
· It also offers some form of capital protection. That protection is called ‘hard’ – you get your money back regardless of the index level. Some structured products offer an alternative which is called ‘soft’ protection – all your initial money back provided the underlying, tracked index, doesn’t fall by XX% from its initial level. The XX is usually anything from 10% to 50%.
· In this case it’s structured as a closed end investment trust – which you can trade in and out of on a real time basis every day. Other variants of this model include investment notes – basically the same product – or fixed term bonds.
· No income. If you’d have bought the iShares tracker of this self same index you’d currently be receiving a princely yield of 2.37% per annum. The structured product pays nothing.
No Free Lunch
There are no free lunches in economics – all potential reward and all removal of risk comes at a price. In the case of this very impressive structured product, that cost is the income.
· Remember that 2.37% income stream from the equivalent iShares product. Over six years, in compound terms that could be worth as much as much 15%. In the structured product you don’t get it
· You also don’t receive the interest you could have made if you’d have held cash instead. Over six years, that could be as much as 30% in compound terms.
That last, lost interest income bit is not ‘lost’, so to speak, on the issuers. They take your money and effectively invest it in two products
· The first is in effect a zero coupon bond issued by various banks. The bond is intended to return a fixed amount at a specified point in the future, and that amount can be set to match the investors' original investment, or a proportion of it. Since the bond is 'zero coupon', i.e. it will not pay any interest in return for the use of the investors' money during its lifetime, the amount required to secure the level of eventual return is worth less in today's terms. This 'present value' of the future return will vary according to the period involved and prevailing interest rates - the longer the period and the higher the rates, the lower is the cost of the bond that provides capital protection. The banks that buy the bonds might for instance guarantee to pay out the full 100p in six years time less the interest – in our example say 25p. This bond might cost say 75p in the £1 – in 5 years time they guarantee to pay the 100p but in the meantime the bond holders will reinvest the 75p per share they give you in high yielding mortgages , for instance, which will yield them more than 5% per annum. So, take that notional 75p from £1, and you’re left with 25p which can help fund the following…
· A long dated call option which pays out the 180% upside. For the derivatives outfit that issues the option, the equivalent of 20p in the £1 could be a good deal. If the index doesn’t rise at all, they make 20p profit – remember there’s no need to pay out if the index falls. If the index rises they have to pay that 180% gearing, but someone in the complex structure of the options universe also benefits from that lost income stream – 2.37% compounded up over six years could be worth as much as 15% or 15p in the £1. So that 15p yield stream can be added to the 20p option cost, making 35p on the £1. Next comes the risky bit for the options issuer. If the index rises moderately, say 20% over the six years, they have to pay out 36p. Now bear in mind that they make the 20% underlying index profit anyway, plus they get income from holding the index, plus the initial option price i.e they’re in profit. But if the index doubles – by 100% - the option writer has to pay out 180p on the £. Suddenly that initial 20p per £1 option price, plus the 100% gain, plus the accumulated yield (15%) begins to look a little more inadequate. Still, back in the real world, the chances of an index doubling over six years are low – not impossibly low but worth the risk!
In essence, the structured products industry we’ve just described is built on a relatively simple investment idea wrapped up inside the complex business of derivatives.
Here’s our very summarised take on structured products.
We, the issuer, promise to pay you, the investor, a return, based on tracking an index, and in return we take the income flow and buy a) some protection for your money and b) an option that pays out the upside if the index does indeed move ahead.
Now there are of course an enormous number of variations around this one theme. These include
· Structured products that don’t pay out a fixed upside based on an index but an income instead
· Structured products that pay out on a reverse profile i.e they only pay out if the index falls
· Structured products that only boast soft capital protection or no capital protection at all
The table below details how these variants on the structured product theme take shape in the real world.
