The recent recession fears in the US have left many investors,
both foreign and local, in a state of worry. Stock markets
around the world have felt the brunt of the housing crisis
and subsequent credit crunch and while the local market
has not shown much reaction, it still remains a real possibility.
Investors have once again lost confidence in the equity
markets and are seeking safe havens for their hard-earned
money. While this behaviour is mainly driven by emotion,
it is quite common, as the investor ignores all the principles
of long term equity investing in the noise and confusion.
Nevertheless, one thing is for sure, there is no need to
resort to hiding your money under your mattress.
The natural and most common strategy that investors would
take when they become less risk tolerant is to restructure
their portfolios accordingly. So for instance, an investor
who may have been in an aggressive portfolio (90 per cent
equity; ten per cent fixed income) may restructure assets
to balance the portfolio (60 per cent equity; 40 per cent
fixed income) or he may have become so risk adverse that
he may seek to hold a conservative portfolio (32 per cent
equity; 68 per cent fixed income).
While the above example would have the desired effect of
mitigating risk, one must be reminded that the lesser the
risk the lesser the return.
However, the above example is not the only investment solution
to dealing with low-risk tolerance. Thus, I would like to
use this article to introduce you, if you have not been
already, to a sophisticated investment vehicle known as
structured products. These are prepackaged investment vehicles
designed to meet specified risk-return needs which cannot
be met from standardised financial instruments in the markets.
Returns are generally linked to the performance of a benchmark
or underlying asset such as interest rates, equity markets,
commodities or even foreign exchange markets. However, one
of the main benefits or attractive features of structured
products is their ability to offer the investor either full
or partial principal protection.
Also, it is important to note that structured products can
be designed for any risk profile, that is, products can
also be structured for the aggressive investor who is very
risk tolerant. Thus, these products can be incorporated
into your asset allocation mix to ensure portfolio diversification.
Indeed, as the name implies, structured products are designed
to specifically target the needs of investors in terms of
their individual risk profiles, return requirements and
market expectations. Generally, they are created through
the use of derivatives and other financial instruments which
have significant risk/return and or cost saving structures
that may not be achievable with other standardised investments
in the marketplace.
These products were originally popular in Europe but have
become quite the trend in the US. Various products are offered
by well established investment banks worldwide, such as
Morgan Stanley, UBS Investment Bank and JP Morgan Chase
to name a few. An example of a structured product offered
by UBS Investment Bank which provides long-term equity exposure
with principal protection is the UBS Principal Protected
Note which is tied to the S&P 500 index. This is suitable
for an investor who seeks long-term exposure to the US equity
market with limited downside risk.
Such an investment provides for a degree of S&P 500
exposure over the term (typically four to seven years),
while offering full principal protection at maturity. It
may be used in planning to meet future obligations (such
as retirement or college), or to lock in gains from the
sale of equities and maintain some market exposure.
The options available with structured products are endless
and can become very complex in nature, which is beyond the
scope of this article. However, as with any other financial
decision, one must always be aware of the risks or disadvantages
involved. The most common risk with this type of investment
vehicle is the fact that there is a lack of liquidity since
products can be highly customised to suit individual needs.
Notwithstanding, investments in structured products are
more of a buy and hold investment decision since returns
are mostly realised at maturity, thus liquidity should not
really be an issue.
Also, holders of structured products should ensure that
they carry out proper due diligence on the issuer of the
product to ensure credit quality. This is because products
are the legal liability of the issuing financial institution
and not the underlying benchmark or asset. This should not
really be a major problem since, as mentioned previously,
some of the worlds leading financial institutions
issue these products.
Also, consideration should be given to pricing transparency
as there is no standard for pricing. Thus, it is harder
to compare the net-of-pricing attractiveness of alternative
structured products than it is, for instance, to compare
the net expense ratios of different mutual funds or commissions
Many structured product issuers work the pricing into their
option models so that there is no explicit fee or other
expense to the investor. This may also be seen negatively
since the investor is unaware of the implicit costs.
Without a doubt, structured products can now offer the individual
investor the opportunity to invest in what was once primarily
institutional ground. These products can be an attractive
addition to portfolios as they have the unique flexibility
to meet specific objectives. Additionally, structured products
allow investors to protect their principal in highly volatile
markets or allow them to profit in the flattest of markets.
So forget the sleeping pills. Instead, contact your investment
adviser today and find a structured product that is tailored
to meet your financial goals.
Information sourced from: The Structured Products Association;
UBS Investment Bank; Investopedia & Wikipedia
Senior Research Analyst
West Indies Stockbrokers Ltd (WISE)