A revolution in risk-reward
More Structured Products Contemplations
by Ron Yair, Try Enterprises Inc., 2/15/05
“We exist for a reason,” says Ron Yair of TRY Enterprises. The market in general has not been able to deliver the anticipated level of returns to satisfy many investors. We put our knowledge and expertise to work trying to satisfy a tremendous amount of appetite among very many different investors, to deliver enhanced returns combined with high degree of safety. Financial Structured Products are the solution.
“There is a quiet revolution beginning in the investment world which offers ever-better deals for those who hate losing money” says Nick Louth, MSN Money special correspondent.
“We all like the idea of making money. But many of us fear that if we put our own money in the stock market, we might lose some or all of it.”
Perhaps it’s time for a second look. Last week we looked at the latest National Savings guaranteed equity bond, which promises you full participation in any rise that the stock market makes over five years, with an extra 10% on top, but guarantees you will still get all your capital back if the market falls.
This is not the only product of its kind. The Nvesta Secure Tracker Plan 3 offers 105% of any rise in the FTSE 100 index of leading UK shares over a fixed six-year period, with a money back guarantee if the market falls. There are dozens of other plans, with varying degrees of protection and varying levels of upside participation.
Why not have your cake and eat it?
These are all products which are designed to cater to those investors who want what we were always told was impossible: to get more than our fair share of reward without taking our fair share of risk. So how is it possible?
These bonds and funds are constructed with derivatives; complex financial instruments such as options or warrants which derive their value from an underlying security.
In this case the underlying security is the value of the FTSE 100, an index of shares in Britain’s biggest companies. The flexibility of these derivatives allows them to either be used as a way to lock-in a certain return (known as ‘hedging’), or to magnify the performance of the underlying security.
‘Put’ options, which are contracts which allow the owner to sell a particular security at a known price at any time until expiry, tend to be used as the former. ‘Call’ options, which give identical rights except to buy, are used for the latter.
In recent years, the cost of buying these derivatives has been high, and it would have been impossible to bundle together competitively enough of each to allow a product to both guarantee base capital and get full returns.
However, the dramatic fall in volatility of the stock market in the last year and improving price efficiency of derivatives, means that you really can have your cake and eat it too.
What is happening here is not the impossible. The risk involved in offering a guarantee of a particular value in the FTSE 100 well into the future is still there, but has merely been parceled up and sold off to whoever provided the other side of the option or warrant deal.
The plan providers (The Issuers) have effectively taken out underwriting insurance through the derivatives markets they are using. The improved efficiency of the market in pricing such deals, and the low volatility of prices has ensured that excellent deals are out there.
After Equitable Life, we can be forgiven for not taking guarantees seriously. Equitable Life based its guarantees on expectations of future returns and assumption about the outlay to annuity holders, based on its experience of what had happened in the past. These products are not like that.
The mechanisms that underlie these products do not rely on assumptions, but are priced for every possible level of the underlying index or benchmark. While the plan sponsor can always go bankrupt for other reasons, it would not be because of assumptions of future returns made in these products. And for the Treasury-backed products, of course, you get your money, full stop.
Terms improving all the time
Just look at how National Savings has improved its offering in the last six months. The 5th series of guaranteed equity bond offered 100% of the FTSE 100’s rise over five years, capped at 60% with your capital guaranteed.
The 6th series offered 95% of the FTSE’s rise, again with full capital protection, and now we have 110% of the rise being offered. Indeed, if these products go on improving as fast as they have over the last year, then they will transform the fund management industry.
Not just for the risk averse
Even for experienced investors, structured products are a useful component for a portfolio. They perhaps need to sit side by side with income generating assets such as bank shares or government bonds (gilts) and those that resist inflation well such as property or index-linked gilts. There are implications for long-term returns too. Setting at zero those five year periods in equity history when prices fell would skew the expected average real annual return much higher than the 5.0% a year we have actually experienced over the last century. Just think, no Wall Street crash or depression, no oil crisis bear market and no burst Internet bubble.
Taxes and fees
Although the National Savings guaranteed equity bond is taxed as income, most of the other plans are treated as capital, which “has a distinct advantage for most investors given the £8,200 a year capital gains tax allowance.”
Please contact TRY Enterprises at www.TRY-Inc.com should you have any questions, or simply interested in learning more about Structured Products.
The mechanisms that underlie these products do not rely on assumptions, but are priced for every possible level of the underlying index or benchmark.