Even though I’ve traditionally tended to write for IFA friendly publications, my favourite subjects have always tended to elicit horror amongst most financial professionals.
ETFs – complex stuff involving derivatives.
Investment Trusts – listed funds, no trail.
Structured Products – gasp, horror, stuff that will get me in trouble with the FCA.
While most advisors have tended to wax lyrically about absolute returns funds – with outfits such as Standard Life with their GARS products figuring prominently – I’ve always tended to prefer structured products as a sensible middle ground, equity based investment solution for more defensive investors. I’ve dug around inside many an absolute returns portfolio and almost completely failed to understand what they invest in, whereas structured products seem to me to be much more sensible. Defined returns investing for adults. Clearly, I’m referring here to the sensible stuff sold through IFAs and bought by a legion of wealth advisers – not the junk sold on the high street to unwitting members of the public.
In essence, its Defined returns investing for adults. Unfortunately, though if you spend enough time hanging around the slightly rarefied world of structured products, you’ll inevitably run into what I think I can safely call the brand name problem. There are some great issuers out there but by and large, it’s still an industry dominated by very small houses using very big banks names as collateral for their products.
Which is a pity because a well-constructed structured product should be suitable for a very large number of investors. Take the classic
Take the classic auto-call or kick out plan – by far the most popular product in structured products land. In essence, it’s not a complicated beast.
– Pick a reference index or benchmark, such as the FTSE 100.
– I the issuer promise, contractually guarantee, to pay out a fixed return – usually between 4 and 10% – in any one year if that index increases in value, even by one point from the issue level.
– If the index doesn’t move upwards but tracks a little lower, I then sit tight and wait for the next year, the second year. Again if the index finishes above the initial level, I have the opportunity of picking up said return (and the last years return as well). This process carries on for a number of years, with each observation date marked and your redemption opportunity.
– Again if the index finishes above the initial level, I have the opportunity of picking up said return (and the last years return as well). This process carries on for a number of years, with each observation date marked and your redemption opportunity.
– This process carries on for a number of years, with each observation date marked, giving the investor a redemption opportunity.
– Usually, there’s also some form of capital protection barrier which is related to the benchmark index. This dictates whether you receive your money back. If the barrier is breached and the index collapses in value, your capital is at risk. If the barrier isn’t breached, but the index has fallen from its initial level, you get your money back, usually without any capital loss – but no annual payouts if the index hasn’t increased in value as described above.
Walk away from the language and you can see a simple form of contractually enforced defined returns, with collateral provided by big banks (obvious credit risk there). In essence these auto-calls or kick out plans are ideal instruments for a more defensive investor who wants more upside opportunity than say high yield bonds (and more volatility) but less risk (and less volatility) than holding a straight FTSE 100 tracker. In an ideal world, this kind of investment will give you a target return for most years of around 6 to 8% per annum although you won’t be entirely saved from a nasty equity market slump.
The UK really is different
In a great many countries structured products, especially marketed as certificates, are hugely popular with retail clients and advisers, whereas in the UK very few advisers use them and even fewer direct retail clients. Precisely because they sound a little more complicated than an average equity income fund, most investors tend to run away. But dig around inside some equity income funds such as the Schroders Income Maximiser range and you’ll find structured products. Crucially dig around in many balanced/defensive/absolute returns portfolios supplied by wealth advisers and you’ll also find an articulated lorry load of structured products. Many of these come from a specialist outfit called Catley Lakeman for the last few decades.
A little over four years ago I wrote an article about their latest product, a fund which pooled together a wide range of the auto-calls they’d issued to wealth advisors.
It was called the AHFM Defined Returns fund, and was run by Atlantic House Fund Management, the investment arm of Catley Lakeman. At the time it struck me that this was an innovative solution for many middle-of-the-road wealthy clients: you want some equity upside, you want a likely return of about 6 to 8% a year, but you also want a diversified fund structure with lots of different issuers. This fund ticks many of those boxes and its charges are also reasonable especially when compared to the absolute returns funds – the AMC is at 0.55% with a total cost of ownership just under 0.80%.
The fund now has just under £300m in total assets and has recently launched a distribution class which aims to give out about 4% per annum. So, what does the fund invest in ? According to the managers the fund “aims to return 7% to 8% per annum over the long term in all but severely negative
According to the managers the fund “aims to return 7% to 8% per annum over the long term in all but severely negative markets enable retail access to defined return instruments (DRI), more traditionally held by institutions and invests in a diversified portfolio of 25 to 50 DRI”. In total 98% are auto-calls but actually, just under 75% of its current net holdings are in gilts or cash with the largest direct bank exposure to HSBC. If we assume that the overall market (mostly FTSE but other benchmark indices as well) doesn’t move at all, the gross redemption yield is currently running at 6.91% which is bang in the middle of the range of returns I’d expect. Correlation is closest to the FTSE 100, at 0.80. One last point – most capital protection levels within the underlying structures are running at between 30 and 40% below the issue level for the benchmark index.
A typical product is something like an ‘autocall’ DRI, linked to the performance of the FTSE 100 & S&P 500, designed to return an annual return of 8.9%.
This “typical” product structure goes a little like this:
▪ On each anniversary if both indices are above a set price (100% of initial yr. 1, 95% yr. 2, etc.), capital +8.9% per annum is returned to the investor
▪ On each anniversary, if either index is below the set price, the DRI rolls for another year
▪ On the 6th anniversary the DRI matures – only if at least one index is below 65% of the initial price do investors lose initial capital
The chart below maps out this complex structure of defined returns.
If we imagine that there are dozens of these structures in the fund, one can immediately see what I think is a big selling point – diversification. Lots of different auto calls linked to different reference benchmarks including the FTSE 100 and the S&P 500. All the investment selection is done by the Catley Lakeman team.
How about performance?
According to the managers from the fund’s launch in November 2013 through to the end of June 2017 it outperformed FTSE 100 by 4.17%, and the Investment Association Absolute returns category by 18.55%.
In terms of discrete year returns:
2014 – 3.3%
2015 – 4.36%
2016 – 11.8%
YTD end June 5.65%
As you’d probably expect volatility has been somewhere between levels for the FTSE 100 and high yield bonds – less than equities, more than bonds.
This second chart shows how this fund might work for investors. As I’ve almost repetitively said before, this kind of investment solution works well for those investors who aren’t out and out equity bulls (like me) but who want some (though not all) of the upside potential from equities.
As the fund managers explain, this fund is likely to “outperform equity indices in stagnant or negatively trending markets but in strong bull markets it is likely to underperform”.
Crucially if the market completely tanks, these kinds of investments probably won’t protect you very much.
My bottom line? I simply can’t understand why so many defensive, cautious retail investors opt for absolute returns funds when the alternative is a professionally managed structured products solution. I’d like to say there’s competition for this particular fund but there isn’t which means that AHFM DR fund is probably the best bet as a funds solution for those investors looking for a defined return.