Providing a level of downside protection

A STRUCTURED product is a financial instrument with a defined investment outcome based on predetermined parameters.

The primary appeal of structured products is that they provide a level of downside protection while still allowing investors to participate in market upswings.

These investments are only starting to gain momentum in South African financial markets, even though the global market for structured products is worth $2 trillion (R30trln), of which Asia represents half.

By comparison, global mutual fund assets under management total around $46trln.

Due to its complexity, structured products were traditionally restricted to high net worth individuals or institutional investors, but they are now becoming more accessible to retail investors.

This should result in a significant popularisation of structured instruments.

Structured products are generally defined in terms of maturity, capital protection barrier, pay-off and an underlying asset to which the product’s return is linked.

The products typically mature after 3 to 5 years and have a level of protection if the underlying asset loses value.

As long as the underlying asset is not down by more than the protection amount at maturity, the investor will receive their initial investment back in full.

Structured products generally provide downside protection of up to 40 percent.

Most structured investments are hybrid securities that have a bond component and embedded derivative(s).

A derivative is a financial security with a value derived from another asset or benchmark, such as an index, single stock or exchange traded fund.

The derivatives most commonly used for structuring these investments are options.

An option is the right, but not obligation to buy or sell an underlying asset at an agreed price and date.

Consider R100 000 invested in a structured product with a five-year maturity, 80 percent minimum upside return, S&P 500 Index as underlying asset and principal protection of 30 percent.

It would return R180 000 as long as the index ends above its initial level.

If the index returns at maturity exceed 80 percent investors also participate in the excess returns.

Should the index end below its initial level (up to 30 percent lower) the initial capital of R100 000 is returned.

If the index ends more than 30 percent lower, investors share the full loss. Capital is at risk if investors sell before maturity with an underlying asset level below the initial level.

Essentially, such an investment can provide South African investors with underlying offshore investment exposure, but with much improved risk-return prospects compared to investing in the underlying index directly.

To invest in structured products investors are required to have stockbroking accounts and to use financial advisers with Financial Sector Conduct Authority category I and II licences.

All product fees are generally priced into the product and will not affect the investor’s return.

In South Africa Investec makes an active market in its structured products listed on the Johannesburg Stock Exchange.