Investors often ask about the relative advantages and disadvantages of retail structured products versus unit trusts. Paul Hutchinson sets these out.
Unit trusts were first introduced in South Africa 50 years ago as an investment vehicle for the ordinary investor. Essentially, they were designed to give everyone access to the wealth-creating potential of the Johannesburg Securities Exchange. Until then, this capability was only available to institutional investors and the already wealthy, via private share portfolios. The advent of unit trusts meant that investors with relatively small sums of money could access the JSE via monthly debit orders for the first time. Today, the unit trust industry has evolved to include a vast array of funds, from asset- or sector-specific to multi-asset, and from local to offshore. Typically, these unit trusts can be accessed from as little as R250 per month, or a R1 000 lump sum, in contrast to the R50 000 – R100 000 minimum lump sum common for structured products.
Protection from fraud – we live in a world where we regularly read about investors being defrauded or losing their entire investment capital. Examples of these schemes are plentiful and include the Kubus milk culture scheme of the early 1980s, the Leaderguard foreign exchange currency scam, and the Masterbond and Blue Zone property development schemes. Investors can take comfort in the fact that unit trusts are well-regulated by the South African Financial Services Board in terms of the Collective Investment Schemes Control Act (CISCA).
Additionally, each unit trust scheme must appoint an independent trustee and custodian, who must ensure that the unit trust fund is run both according to its mandate and in terms of the requirements of CISCA. Importantly, the custodian holds all unit trust fund assets on behalf of investors, separating them from the manager’s own assets. Simply put, if something happened to the asset manager, the investors’ money would remain protected. Therefore, investors need to be far more vigilant when considering making an investment that is not as well-regulated as a unit trust.
Structured products are underwritten by investment banks, which are themselves well-regulated and supervised by the South African Reserve Bank. However, the capital protection element of the structured product is provided by a counterparty. The investor’s risk is that the counterparty is unable to meet its obligations or that it has insufficient liquidity at the time the payment is due. Clearly, using the most secure (highest investment grade) banks can mitigate this risk.
Transparency – unit trust managers are required to disclose a myriad of information that assists investors to make informed decisions. CISCA governs marketing material, which has to be published in language that is easy to understand. In addition, comprehensive disclosures including fund prices, all fees and charges and their method of calculation, the fund’s total investment charge, quarterly changes to portfolio holdings and fund performance are required.
In most cases the design of the retail structured product can be quite complex, making it essential for investors to understand how the product will perform under various market scenarios (e.g. where the product offers 100% capital guarantee at maturity if the reference index has not fallen more than 30% at any point during the term). Investors must also consider the costs inherent in the product, both the direct (e.g. management and distributor fees) and indirect (e.g. where the return is based on the reference index ex the dividend yield – the historic dividend yield of the FTSE/JSE All Share Index is close to 3% p.a.).
Furthermore, while many retail structured products now provide a daily price, this is not necessarily the price that an investor will get if they disinvest prior to maturity. There is no requirement for independent performance reporters, such as Morningstar or Profile Data to generate comparable performance reports for structured products.
Professional investment management – unit trust funds are managed by investment professionals who have the qualifications, experience, time, resources and access to information to make informed investment decisions. By comparison, many structured products are not exposed to a particular investment manager’s philosophy, nor do they benefit from the insights of a seasoned investment professional.
Convenience and liquidity – investing into a unit trust fund is a relatively simple exercise and is becoming simpler as unit trust managers move towards online investing and transacting. Furthermore, CISCA requires daily dealing in unit trust funds. This means that an investor can buy and sell units on any day that the Johannesburg Securities Exchange is open and receive that day’s unit price. Furthermore, in South Africa investment proceeds are typically repaid within two to three working days. As structured products are designed to be held until maturity, anyone looking to exit early will likely have to sell out at a significant discount, which may result in a loss. The time taken to process a structured product repurchase (in the event that it is possible) is also likely to be materially longer than the two to three days for unit trusts.
Tax efficiency – income generated by the assets in which the unit trust fund invests (i.e. interest income earned from income-generating assets and dividend income earned from equity and property investments) and any profits arising from their sale are not taxed in the unit trust fund but rather in the hands of the investor. Investors are therefore able to benefit from any applicable tax exemptions on income earned and are able to delay the payment of any capital gains until such time as they sell their investment.
With respect to a structured product, it is important to establish the wrapper used and the term of the investment as these will impact its tax treatment and efficiency.
A retail structured product offers a number of distinct advantages, perhaps the most important being the level of certainty provided as to how the product will perform under particular market conditions.
Other advantages of structured products include:
Capital protection – most structured products offer explicit capital protection at maturity, be it 100%, or a smaller percentage if the product offers higher participation. It is important though for investors to fully understand the terms of the guarantee, as in some instances the guarantee may only apply in the event that the reference index does not fall by more than a specific amount. Note also that capital protection comes at a cost, which is generally embedded in the payout profile of the product.
It is worth noting that while a capital guarantee does provide peace of mind, it may prove wasteful for longer-term investors. Figure 1 shows the rolling five-year performance of the FTSE/JSE All Share Index. You can see for the period shown, which includes the global financial crisis, there has not been a negative rolling five-year return: the minimum return being 5.9% p.a., the maximum being 36.3% p.a. and the average rolling five-year return being 17.4% p.a.
Figure 1: Rolling five-year returns of the FTSE/JSE All Share Index
Source: Morningstar and Investec Asset Management as at 31.05.17.
Figure 2: Rolling five-year returns of the MSCI ACWI NR USD
Source: Morningstar and Investec Asset Management as at 31.05.17.
The picture is somewhat different for a dollar investment in global markets, where Figure 2 shows that the MSCI All Countries World Index (ACWI) has delivered a negative rolling five-year return 25% of the time for the period illustrated, with a minimum rolling five-year return of -4.5% p.a., a maximum return of 20.5% p.a. and an average return of 5.5% p.a.
Enhanced (geared) returns – some structured products are designed to provide greater than 1:1 participation to the reference index, which may come at the cost of not receiving any dividends. In these instances, the total participation is likely to be capped at a certain amount (e.g. 200% participation in the index, capped at 30%), whereas the performance of unit trusts is uncapped.
The ability to deliver in flat or even falling markets – a defensive structured product can be designed to provide a pre-determined return in the event that the reference index falls by a certain percentage over the investment period.
Less restrictive investment guidelines – structured products are not restricted by the requirements of CISCA, and specifically Board Notice 90 which details underlying investment limitations, including diversification requirements. This broader investment opportunity set can assist in improving the risk and return characteristics of the structured product.
The relative advantages and disadvantages of unit trusts and retail structured products are summarised in the following table:
|Unit trusts||Retail structured products|
|Safety of assets||✓||✓ (highest investment grade)|
|Professional investment management||✓||N/A|
|Convenience and liquidity||✓||X|
|Tax efficiency||✓||Dependent on structure/wrapper|
|Certainty of outcome||X||✓|
|Enhanced returns||X (uncapped)||✓ (but capped)|
|Ability to perform in flat/falling markets||X||✓|
|Restricted opportunity set (limits applicable)||X||✓|
In conclusion While retail structured products remain out of reach of investors in the wealth-creation phase of their investment lives, for first-time, shorter-term or conservative investors, a structured product may provide a useful entry point to a growth-oriented investment. As an alternative, these investors could consider a multi-asset, absolute return fund, such as the Investec Cautious Managed Fund, which targets inflation plus 4% p.a. over rolling three years and no negative returns over rolling 18 months, or the Investec Opportunity Fund, which targets inflation plus 6% p.a. over rolling three to five years and no negative returns over rolling 24 months. Investors seeking an offshore investment could consider the Investec Global Multi-Asset Income or Global Strategic Managed funds. Given the complexity and importance of this decision, investors are best served by seeking professional investment advice, tailored to their individual circumstances.
WHAT IS A STRUCTURED PRODUCT?
A simple definition of a structured product is that it is a contract (an agreement) where the product provider promises to pay the investor a return referenced to the performance of an asset, for example, the FTSE/JSE ALSI 40 Index. While structured products can be designed to offer either income, participation, growth or a combination thereof, the most basic structure will purchase a zero coupon bond, which accumulates interest to ‘guarantee’ the return of the investor’s initial capital at maturity and a call option to deliver the capital gain. A call option is an agreement that gives an investor the right, but not the obligation to buy a stock, bond, commodity or other instrument at a specific price within a specific time period.
Sources: wikipedia.org; Investopedia.com
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