Structured products have been around for a long time. We have always viewed them to be a poor quality products for our clients so they are not something that we use. But people do use them, otherwise they wouldn’t have survived as long as they have. They have always been complex products which traditionally used the interest gained off your money to generate the guarantee. With interest rates nonexistent for over a decade now, more complex structures have had to be used to make these products. So much so, that the Central Bank recently issued a letter addressing these products and their complexity. In it, the Central Bank sets out six minimum requirements in a firm’s governance processes for these products. I am going to look at three of them.
Where complex features are proposed, firms must consider if they are appropriate for the retail market and whether they are likely to be understood by the target market.
The target market for these products are people who leave their money on deposit with a bank or post office. With inflation high and deposit interests nonexistent, they are tempted to part with their savings in a bid to try to maintain the real value of their money. They tend to be an unsophisticated investor who don’t understand the stock market. They tend to be more worried about the short term losses of the markets rather than the long term gains. The capital guarantees offered by these structured products appeal to them. At least their money will be safe.
So what are the chances that they know what a “decrement index” is? These are complicated structures that mirror an index less a predefined dividend. The reason for getting rid of the dividend is to reduce the price for the product producer. But they do not deduct the actual dividend, which will vary, but a fixed percentage/ amount at the outset. When the market is stable or steadily increasing, decrement indices tend to be more beneficial to investors compared with an index which doesn’t include dividends. However, in adverse market conditions, decrement indices may result in a large reduction in returns.
An example is the a joint Barclays/ BCP product that takes 5% each year off the underlying total return index. If there is no return on the index over the 10 year of the bond, the decrement index falls by 50%!
To be honest, I had never heard of decrement index before I started reading up about this subject. I had to read a number of different articles before I began to get an idea of what it meant. Do you think someone who doesn’t understand markets can follow this?
Where past performance (back-testing) information is presented, firms must ensure that it is fair and balanced, supported by clear narrative and context, and does not diminish the potential likelihood of capital loss. Care must be taken to avoid presenting an overly optimistic or unbalanced picture of the likely investor outcomes.
There is nothing better than some examples of past performance to put someone’s mind at ease. Even though we are told that past performance is no guide to future performance, everyone looks at past returns and are guided by them. Say you are a nervous investor who has only ever left your money in cash but are thinking of investing some of your savings to stave off inflation. An “advisor” tells you that in 1,939 different back-tests, the investor got their money back plus 5% interest after 3 or 4 years. Wouldn’t that put your mind at ease?
Retired actuaries Brian Woods and Colm Fagan have looked into this. They discovered that the periods used for the back-test started in 2010, the start of one of the best periods of stock market growth. Each new test started the day after the previous one, meaning the difference in returns is not going to be that different. Woods and Fagan likened it to a car manufacturer completing a test drive from Dublin to Westport and claiming 1,000 successful 100 mile road tests of the car, with each test starting 100 yards after the previous one.
In models that Woods has created, he found there is almost a 15% chance that investors will lose around 70% of their investment. The investment suddenly became a lot riskier when you are looking at it like that.
In the case of complex products such as Structured Retail Products, firms must take special care when designing and presenting marketing information to ensure that individual statements, as well as the tone and overall content when read together, remain fair, clear and not misleading.
These products always sell the upside. Capital guarantee, great back-tests returns, low risk. The downside risk is always included in the 20+ page small print product brochure that they know you are unlikely to read or understand. These downside risks tend to be absent from the 1 page flier. Why is that?
If these Central Bank requirements are followed, the target market for these products will be limited to actuaries and those involved in finance. I will admit, they are far beyond the scope of my understanding and I bet that most advisors who sell these products will not be able to explain how they work in plain English.
As to whether these products will be banned, we already know the answer to that. Woods and Fagan met with the Central Bank who told them there has to be European harmonisation on rules. Ireland can’t “ban” products that are allowed in other countries.
So it looks like these products will still be around. If you are thinking of investing in one of them, don’t get caught out by the headline figures of great returns. But ask yourself if you are happy with 4 -1 odds of losing around 60% of your investment versus the chance of earning 5% a year plus money back after three or four years if the 4-1 shot doesn’t come up.
02 May 2022