Structured products are used by organisations such as banks, investment companies, asset managers and multi-managers for capital protection, hedging, yield enhancement and targeted offshore exposure.
Insurers and retirement funds use structured products for liability-matching and for investments that deliver predictable outcomes within regulatory limits.
According to Samukelo Zwane, head of product at FNB Wealth and Investments, structured products offer institutions the ability to tailor outcomes in ways that traditional assets cannot – for example, creating downside protection, enhancing yield in flat markets or accessing offshore exposures efficiently.
Some structured product providers have noted a recent increase in demand for equity-linked and credit-linked notes from retirement funds.
A key advantage of equity-linked structured notes is their ability to outperform fund benchmarks while using cost-effective passive investments, but this must be weighed against the lack of liquidity over the term of the investment. Liquidity issues mean asset managers and retirement funds may only be able to make small allocations. After a market rally, structured products can provide protection, and after a fall they can offer enhanced returns from the recovery.
Investec’s head of institutional coverage Richard Swain notes in a recent Citywire article that there is an increasing interest in structured notes being used for portable alpha – derivative-based equity index returns combined with alpha from collective investment schemes and a capital guarantee that limits risk to the original investment in a portable alpha note.
Swain writes that fixed outperformance notes are also being used to deliver a guaranteed return above local or global equity indices with no capital protection.
According to Swain, structured notes offer an efficient way to hedge exposure in uncertain markets as traditional hedges are expensive.
Roland Rousseau, an independent listed product strategist, says structured products can provide guarantees that lower market timing risk faced by members close to retirement. Traditionally, retirement funds have moved members out of equities and into cash and bonds in the years immediately before retirement to mitigate this risk.
Rousseau points out, however, that this can cause members big losses – for example, those who were moved out of equities just after the pandemic because they were close to retirement age effectively lost 20% to 30% of their life savings as they were locked into cash and did not participate in the subsequent rally in equities.
Rousseau believes that retirement funds and multi-asset balanced funds in South Africa should use structured products to a much higher degree and rely less on fund managers’ unreliable “skill” and market timing risks.
Retirement funds and Regulation 28
When structured notes are included in South African retirement products, investors or funds have to be cognisant of Regulation 28 of the Pension Funds Act.
Francois Strydom, portfolio manager at Momentum Securities, says it is important to consider the strictest definition of Regulation 28 and who has issued the structured note. If a note was issued on a global equity index by an offshore bank, it should not be regarded as equity exposure. Instead, it is treated as credit issued by an offshore bank, which is limited to 5% per bank under Regulation 28. If, however, the structured note is issued by a local issuer, the limit is 25% per issuer with market cap more than R30-billion.
Auto calls can be useful when there is volatility or the market is going nowhere because all that is required is for the index to be marginally positive over the following few years for the manager to get an alternative source of return – possibly geared participation. This provides diversification.
On a medium-term basis, if an asset manager feels the market is in for a bout of volatility and a structured product offers enhanced participation if the market is up and capital protection, the product may make sense for an element of the portfolio.
Risks for institutional investors
Institutional investors, like retail investors, need to pay close attention to the creditworthiness of the issuer, because the investor ultimately takes on the bank’s credit risk.
Liquidity is another important factor – most structured products are designed to be held to maturity, and early exit can be costly or difficult. Institutions should assess how the product will be valued and accounted for, since mark-to-market movements can affect reporting. Other key considerations include inflation risk and concentration risk.
