Smart Thinking... How to determine risk
How can an IFA can determine the RISK or applicability of a structured product in a client investment portfolio.
[Paper given at Millfield Conference, 2003]
When one looks to assess the increasingly important UK structured product marketplace and the various
Income and Growth
products on offer from product manufacturers there are a plethora of confusing products on offer. Some are good some are bad and some are plain ugly!There are several key risk areas for intermediaries to focus on, in terms of what the product is actually offering and not just what seems to be the usually very attractive advertised headline rates.
An IFA needs firstly to be able to determine the “riskiness” of any specific product and this will determine if it makes up part of the low risk ‘
core’
of the client portfolio ( say 85-90%) or the more risky‘satellite’
portion (10-15%). Investment timeframe is also of critical importance as most structured products penalise an investor heavily if they need to access their cash before maturity.Structured products level of risk adjusted returns, or the payoff profile as it is known, can be assessed based on considerations which together determine the “
total riskiness
”. The questions which should be asked include:What is the actual or real level of Capital Protection offered?
Is the capital protection a ‘soft or conditional’ guarantee?
Can there be any circumstances where a capital loss is sustained , if so what magnitude of loss could occur?
If some of the negative conditions are triggered during the term of the product that offers a soft guarantee, will the client loose £2 for every £1 fall in the value of the underlying reference investment? Is the product in fact geared on the downside?
Is there a “non conditional” or HARD capital guarantee that no matter what happens to the investment the clients capital is all returned in full, NO excuses...
A lot of UK structured products offer high headline returns and these are stated in such a way that as long as the market does NOT fall by say 40-50% you will get all your capital back and the headline returns….. but will any adviser today want to bet against the impact of a SARS outbreak, for example, or some major catastrophic event, be it an act of terrorism or the US invading another middle eastern country, or even, god forbid, Al-Qaeda triggering a dirty bomb in London? Advisers should NOT be in the business of placing a scenario outcome bet with clients funds specifically the ‘core’ component that makes up the bulk of any investment portfolio. Can advisers afford to bet with any real certainty by investing in a product that has a conditional capital outcome and how would you explain to a client that actually they have now lost most of their capital?