Finance - Investing in Structured Products Investing in shares on the stock market has always carried an element of risk, and some smaller punters — and even a scattering of mega-wealthy investors — get as much of a kick out of “playing” the market as dedicated race-course betters do from seeing an outsider they have picked romp home at odds of 60 to one. For on the markets, as at Epsom or Aintree, there are no absolute certainties. Even Britain’s blue chip companies — the top 100 which make up the Footsie Index — are not immune to sudden and unexpected failure. Of course there are completely safe investments — such as fixed deposits in commercial banks (though even these have been known to fail) — in the current climate of historically low interest rates, returns on these rarely keep pace with the declining real value of an investor’s cash. What many want is safety — or at least a semblance of safety! — linked to realistic capital gains or income. Though they are relatively new investment vehicles, “structured products” both meet this need and are also being demanded increasingly by high net worth individuals — a demand which banks are gearing themselves to meet and a ground-breaking area across which SG Hambros is cutting a successful trail. SG Hambros currently puts together as many as four or five structured products a month, Peter Gardner, head of the bank’s product development team, told a banking seminar in London recently. In the past year there had been a doubling in the assets under management of structured products, he added. All very well, but what exactly is a “structured product”? Although no single definition has been established, they can be summarised as financial products which have been created by “combining two or more financial instruments — one of which is generally a derivative — to create a single product,” Bruce Duckworth of SG Hambros (Gibraltar) explains. They are also linked to one or more underlying prices, indices or rates... and payment is set at “one or more future dates.” Generally their capital is protected and returns are contingent on the performance of the underlying investment; or they offer guaranteed or contingent returns — with redemption of capital contingent on the performance of the underlying investment.Because its parent Societe Generale is “ a powerhouse in derivatives” this “helps enormously with the construction of the product” and has given SG Hambros an edge in the area of structured products, Gardner claims. The appeal to individual investors probably lies in the fact that each product is tailored to a specific scenario or to his or her needs, and that it is set in such a way as to mitigate risks from changes in foreign exchange rates or fluctuations in the cost of borrowing. While providing for diversification and the efficient use of an investor’s capital, most structured products also offer the ability to take a “complex” view through a single investment. Inevitably there are also potential drawbacks. As Gardner points out capital protection applies only if the instruments are held to final maturity; in the case of many equity-linked products there can be loss of dividend income; and there is potential volatility in “mark-to-market valuations” as a result of fluctuations in interest rates or the value of embedded options.” The bank is also increasingly offering its clients Constant Proportion Portfolio Insurance (CPPI) structuring techniques — a more sophisticated vehicle that enables active management of the structured product, Gardner told the seminar. “This enables assets to be bought and sold throughout the life of the structure to ensure the optimum level of both risk and investment exposure are maintained,” he explains. In a low interest rate environment such as we have experienced for almost the past decade or so, CPPIs are particularly attractive, the bank argues. “A CPPI structure borrows money to invest in the risky assets — obviously the expected return needs to beat the cost of borrowing,’ Gardner says. “If the interest rate rises and becomes higher than the expected return on the risky assets, the manager will stop the leverage — though not the investment. “One of the problems associated with CPPI is that while the structure allows for the active management of the underlying investments, it does not allow for active management of the leverage,” Gardner admits. However, second generation CPPIs are more sophisticated and increasingly allow banks to limit volatility while more actively managing the multiplier part of the structured product. New techniques allow for the active management of the CPPI parameters including leverage, as well as the underlying investment. These second generation CPPIs have three levels of management, according to SG Hambros: • The alpha of the underlying investment managers — the asset allocation based on market expectations; • The mathematical rebalancing of the CPPI — rebalancing between the underlying investments and the non-risky assets based on market trends; • The alpha of the product manager — the active adjustment of the leverage factor and other CPPI factors, depending on the product manager’s expectations of the markets’ movements.” “Structured products are an investment area that still has significant room to expand and is constantly changing, benefiting from developments in financial engineering and derivatives trading,” a local SG Hambros spokesperson adds.

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