Investments generally carry two key risks; systematic and unsystematic. Systematic risk is usually referred to as market risk or un-diversifiable risk and is risk that is inherent in all market related investments and cannot be removed or mitigated.
It should not be confused with systemic risk which is the risk of loss from some catastrophic event that collapses the entire financial system. On the other hand, unsystematic risk, otherwise known as specific risk or diversifiable risk, can be mitigated through diversification.
Using diversification
Diversification is part of the investment planning process that allows good advisers and wealth managers to add real value to client's portfolios. Diversification is clearly not a new phenomenon and can be applied in many different ways and at different levels, and includes asset type, geographical spread, product type, tenure, pay-off profile and so on. It does seem strange however, that it was only after Lehman's that diversification within structured investments became relevant.
The FSA have of course issued guidance relating to credit and product concentration levels within a client's portfolio for structured investments. However, the nature of this industry can make it difficult for an adviser to access a particular product style from more than 1 or 2 different credits; what if the client has more than the recommended levels to invest? Also, and for the sake of completeness, the Financial Services Compensation Scheme (FSCS) is highly unlikely to apply should an issuer default, making diversification an essential part of an adviser's process when using structured investments.
Mitigating market and specific risks
Unlike mainstream traditional investments, structured investments can help an adviser mitigate an element of both market and specific risks; market risk by using capital protection and specific risk by counterparty diversification. Diversification has been a key theme for Investec Structured Products throughout 2010. We have been offering alternative credits on some structured investments to encourage advisers to diversify credit exposure whilst using the same structured investment with one plan manager.
Diversification is only one way to mitigate an element of counterparty risk. Some providers have developed collateralised structured investments (generally using gilts) as a form of collateral should the issuing bank default. By using collateral, advisers are able to further mitigate bank specific risks. However, should collateral be a one size fits all, or should the concept of using collateral with a Structured Investment be tailored to match different pay-off profiles?
Structured investments come in a variety of different risk and reward pay-off profiles. Some plans offer full capital protection irrespective of movements in its linked index, some plans offer no capital protection and some offer soft protection, generally allowing the associated market or index to fall by say 50% before any capital loss feature is triggered. It makes sense to design any collateralised feature with this in mind, matching pools of collateral to the risk profiles dictated by the product instead of using the same assets to collateralise different products.
Let me explain. A client buying a fully capital protected investment is by definition averse to market risks. They are therefore likely to be interested in collateral that presents, in principle, no further risks to their investment, such as UK Gilts. On the other hand, a client interested in a capital at risk structured investment is comfortable with market risk and also perhaps aware of counterparty risks. Any collateralised option should reflect this instead of simply using Gilts, which can be expensive, and potentially erode too much of the return profile in associated costs. There is little point investing in a capital at risk structured investment where the costs of providing collateral reduce the pay-off profile to the point where the premium paid for taking the risk in the first place is eroded or even wiped out.
Balancing protection and return
At Investec Structured Products we believe that as new products are designed, collateralised options will become more important and perhaps even an integral part of product design. Manufacturers, however, need to build these options in an efficient way to maximise the client benefits with a range of pay-off profiles.
Providing a range of structured investments with risk adjusted pay-off profiles is what Investec Structured Products is all about and this ethos has been carried through to the design of our new collateralised structured investments. We have taken the theme of diversification to a new level which we believe will allow advisers to better match specific investments to client's objectives whilst diversifying counterparty risks in line with recent FSA guidance on product and counterparty concentrations.
Our collateralised Structured Investments
Our FTSE100 Enhanced Kick-Out Plan now has a new collateralised option and our FTSE100 Growth Plan has been replaced by the new Gilt Backed Growth Plan which, is fully collateralised by a portfolio of UK Gilts. The new plan is fully capital protected irrespective of movements in the FTSE100 and therefore by definition fairly cautious in design, so we have used UK Gilts as the collateral.
The FTSE100 Enhanced Kick-Out Plan, on the other hand, is a capital at risk structured investment and we believe that to use UK Gilts would be an expensive and potentially inefficient way to provide collateral. Instead, collateral will be provided by an equally weighed pool of securities in 5 leading UK banks; HSBC, Santander UK, Barclays, RBS and Lloyds TSB. By using this option, clients are spreading their counterparty (or specific) risk across 5 leading UK banks therefore offering efficient strong diversification; why bank on 1 bank when you can bank on 5! The collateral will be held with an independent custodian, Deutsche Bank, and the value of the collateral will be matched each day based on any fluctuations in the value of the investment. Should Investec default, the value of the collateral would be made available to all investors in the product. By using this type of collateral, we are able to keep the return profile competitive.
The three C's: Client Centric Collateralisation
Collateralisation within structured investments is an important development. Combine this additional layer of comfort with the added benefits of diversification and the result is a very compelling investment proposition designed with the client in mind.
Gary Dale
Head of Intermediary Sales at Investec Structured Products
Email [email protected]
