Financial advisors recommending structured products to clients are required to ensure the products are suitable for the client and to make full disclosure of the fees.
The Financial Advisory and Intermediary Services (FAIS) Act’s Code of Conduct obliges advisors to identify the financial product or products that will be appropriate to a client’s risk profile and financial needs.
It also obliges advisors to provide a reasonable and appropriate general explanation of the nature and material terms of a contract or transaction to a client and make full and frank disclosure of any information that enables the client to make an informed decision.
When it comes to structured products, how easy is it to determine the risk-return profile and to disclose all costs?
Evaluating costs
Some structured product costs may be easier to evaluate than others. Costs that are typically detailed are:
- An upfront fee the provider may charge at the start of the investment term.
- Advice fees payable to the advisor.
- Platform fees if the product is made available on an investment platform or linked investment services provider.
- Brokerage fees payable if the investor is using a stockbroking account to invest.
- Fees for any product such as an endowment in which the product is housed.
But there are also costs and fees for the price of the capital guarantees and options that are typically priced into the products which may be less transparent.
Listed products may have to comply with certain cost disclosures included in the listing requirements.
The JSE’s listing requirements previously stated, for example, that the placing document for any structured product must include disclosure of all terms and conditions of the securities, including fees, costs, margins, commissions and charges embedded in the product’s pricing.
The pricing supplement requirements state that embedded fees and their impact on pay-off structures must be disclosed to enable investors to make an informed assessment of the product, which explicitly includes how costs and charges affect returns.
Products that are listed on exchanges in Europe must comply with Markets in Financial Instruments Directive II (MiFID II), which also requires embedded costs to be disclosed, while those listed in the US must comply with Financial Industry Regulatory Authority (FINRA) guidance on complex products and the disclosure rules of the Securities Exchange Commission (SEC). Products issued over the counter by insurers which are not listed on a stock exchange may not comply with the requirements.
Luvhani Makoni, lead specialist for investment proposition at the Liberty Group, says Liberty’s structured products’ pay-off profiles are quoted net of all fees and taxes. This was a deliberate decision to make it simpler for investors to understand, but points out that some providers quote pay-offs before fees.
The effective annual cost for the product is quoted as zero because all the fees have been accounted for in the pay-off profile offered to investors, she says. Liberty’s structured products are not listed.
Roland Rousseau, an independent listed product strategist, says it has become standard practice to quote a structured product’s costs net of fees as this removes the ambiguity of the total cost. He cautions, however, that because some providers do not quote net of fees, investors and their advisors still need to check.
Craig Sher, chief product and investment officer at Discovery Invest, says on Discovery’s endowments, the broker takes commission upfront before the investment is made in the product. Then the normal administration fee for the endowment applies. All other costs are built into the pay-off and the built-in costs are not disclosed.
He says providers take the risk and the margins for any guaranteed plan are not explicit.
Francois Strydom, portfolio manager at Momentum Securities, says the costs of structured products have come down as they have become more accessible – with lower minimum investment amounts and greater efficiencies.
He says the fee Momentum Securities, as the distributor, charges, for example, 35 basis points per annum, the advisor fee and the platform administration fee are disclosed as an effective annual cost and investors must sign the quote that discloses it.
Risk profiles
Structured products may be classified as equity or credit linked, but the products do not behave in the same way as equities or credit because of the interplay between the pay-off and the guarantees. If the product comes with a guarantee it has a cost – a trade-off against returns, so the investor’s need for such guarantees should be considered. An investor with a long investment horizon and the capacity to recover from any market downturns may be better off in a low-fee product that exposes them fully to the market, including earning dividends.
If the structured product is one with gearing, the suitability of the investment risk this presents should be considered and an appropriate level of exposure to such a product should be considered. The JSE listing requirements specify that the placement document for structured products must include the risk profile of the structured product.
The JSE does not provide any further guidance on how to risk profile structured products, leaving it up to product providers to identify the profile and advisors to evaluate whether there is enough in the profile to determine suitability.
Makoni says Liberty’s equity-linked structured products are all classified as suitable for investors with a moderately aggressive risk profile. Despite the guarantees, the product is riskier than a traditional money market unit trust or fund or a fixed income fund. There is credit risk and liquidity risk.
Financial service providers are responsible for making the risk apparent and Liberty’s products are only available through financial advisors who need to explain the risks to investors.
International regulators’ views on profiling
International regulators have issued guidance to structured product providers offering products in Europe and the US.
The European Securities and Markets Authority (ESMA), for example, has cautioned providers to consider several key factors when profiling products, including: risk factors (such as market, credit and liquidity risk); the charging structures; the optionality where derivatives are included; the leverage; subordination clauses; how observable the underlying asset or index is; and guarantees of principal repayment or capital protection.
ESMA says providers and distributors should consider whether the product’s charging structure is clear to the investor, whether the charges will undermine the return expectations and whether the product is compatible with the needs, objectives and characteristics of the target market.
US-based alternative investments company TSG Invest says structured products can include multiple financial instruments and reference complex underlying assets or indices.
The embedded derivatives and complicated pay-off structures can make it difficult for investors and their advisors to understand how their investment will perform under various market conditions, it says.
FINRA cautions against assuming that if the reference asset is suitable that the structured product will also be so, as the product may have very different risk-reward profiles.
It cautions that the derivatives in structured products and the potential loss of capital in many of these products may make them unsuitable for investors seeking alternatives to investing in bonds and more akin to investing in options, particularly when the capital invested is at risk from market movements in the linked asset.
In some cases, it may be necessary to consider whether the investor has a risk profile suitable for options trading.
This means considering if the investor has the knowledge and experience to evaluate the risks and ability to bear the risks of investing in such a product, the regulator says, and suitability must be determined on an investor-by-investor basis, with reference to the specific facts and circumstances of each investor, FINRA says.
The volatility of the linked asset must also be considered when there is a risk of losing all or a substantial portion of the capital as a trade-off for earning an interest rate that is higher than the prevailing market rates.
When advisors consider suitability, they need to consider:
- Whether the term is appropriate.
- Whether the investor is an equity type of investor with a moderate to high risk tolerance.
- If the investor is comfortable with the linked asset.
Investors should never put all their money in a structured product – it should add to the diversification to a portfolio, not make up the entire portfolio. The exact allocation depends on the individual and how the rest of the portfolio is made up.
