Investments generally carry two key risks, systematic risk and unsystematic risk.
Systematic risk is usually referred to as market risk or more commonly known as un-diversifiable risk. In other words, it is a risk that is inherent in all market related investments and cannot be removed or mitigated, it is constant. Systematic risk should not be confused with systemic risk which can be defined as 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 and this is the point in the investment planning process that good quality advisers and wealth managers can add real value to client’s portfolios.
Using Diversification
Diversification is clearly not a new phenomenon and can be applied in many different ways and at different levels including asset type, geographical spread, product type, tenure, pay-off profile and so on.
It does seem a bit strange then that when looking at structured investments, it was only after the Lehmans debacle regarding a relatively small amount of structured investments, that credit and or product diversification came to the fore and ironically has become nothing short of a key investment criteria since.
The FSA have of course issued guidance relating to credit and product concentration levels within a clients portfolio for structured investments. This guidance highlights that no more than 25% of a clients portfolio can be invested in Structured Investments with no more than 10% with any single counterparty.
At first glance these ‘guidance limits’ may seem prohibitive and place unnecessary restrictions on a client’s portfolio however, diversification, as I have said above, is not new and should be a fundamental part of the investment planning process.
Having said that, the very nature of this industry can make it difficult for an adviser to access a particular product style or pay-off profile from more than 1 or 2 different credits with exactly the same terms and risk profile; what if the adviser 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 are able to 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 and we have been offering alternative credits, such as Morgan Stanley, RBS and Santander UK, on some of our structured investments to encourage advisers to diversify credit exposure whilst using the same structured investment with one plan manager.
Diversification is of course only one way to mitigate an element of counterparty risk so in addition, 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 specifically match different pay-off profiles?
Structured Investments come in a variety of different risk and reward pay-off profiles with some plans offering full capital protection irrespective of movements in its linked index, some plans offering no capital protection and some offering soft protection, generally allowing the associated market or index to fall by say 50% before any capital loss feature is triggered.
It would therefore make logical sense to design any collateralised feature with this in mind thereby better 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 and is, therefore likely to be interested in collateral that presents, in principle, no further risks to their investment, i.e possibly UK Gilts. On the other hand, a client interested in buying a capital at risk structured investment is already comfortable with market risk and also perhaps aware of counterparty risks so therefore any collateralised option should reflect this instead of simply using Gilts, which can be expensive, and potentially eroding too much of the return profile in associated costs.
There would seem little point investing in a capital at risk structured investment where the costs of providing collateral reduced the pay-off profile to the point where the premium paid for taking the risk in the first place is partially eroded or, worse still, wiped out!
Balancing protection and return
At Investec Structured products we believe that as new products are designed, collateralised options will become more and more important and perhaps even an integral part of product design in the future. Manufacturers however need to build these options in an efficient way so as to maximise the client benefits with a range of pay-off profiles and not let the protection tail wag the investment dog.
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 now 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 at the same time diversifying counterparty risks in line with recent FSA guidance on product and counterparty concentrations.
Our collateralised Structured Investments
Our FTSE 100 Enhanced Kick-out plan was the first to offer a collateralised version alongside the Investec version. Offering advisers and clients this choice is an important feature in our retail collection as we believe that not all clients view risk and return in the same way.
In the same way as our collection includes plans that offer different protection levels with regards to movements in the FTSE 100 index, our collateralised versions now allow clients to mitigate the risks associated with counterparty exposure by spreading their investment across different counterparties but within the same Investment Plan.
We also replaced our FTSE 100 Growth Plan with the new designed FTSE 100 Gilt Backed Growth Plan which, as the plan name suggests, is fully collateralised by a portfolio of UK Gilts. The FTSE 100 Gilt Backed Growth Plan is fully capital protected irrespective of movements in the FTSE 100 therefore, by definition, fairly cautious in design, so we have therefore used UK Gilts as the form of collateral.
The FTSE 100 Enhanced Kick-out plan on the other hand is a capital at risk structured investment and we believe that to use UK Gilts as collateral would be an expensive and potentially inefficient way to provide this option. Instead, the collateral will be provided by an equally weighed pool of securities in 5 leading UK banks, HSBC, Santander UK, Barclays, RBS and Lloyds.
So, in effect by, using this option clients are spreading their counterparty (or specific) risk across 5 leading UK banks therefore offering efficient strong diversification properties; why bank on 1 bank when you can bank on 5. The collateral will be held with an independent trustee, Deutsche Bank, and the value of the collateral will be matched each day based on any fluctuations in the value of the investment and, should Investec default, the value of the collateral will then be made available to all investors in the product.
By using this type of collateral, we are able to keep the return profile competitive and, in fact, the annualised kick-out payments on our UK 5 bank collateralised option will be at least the same as the single credit alternative asset providers we have used recently.
Following the successful first launch of our collateralised option on the FTSE 100 Enhanced Kick-out Plan we have now added the collateralised option to a wider range of products. This new feature has now been added to our FTSE 100 Geared Returns Plan and our FTSE 100 Bonus Income Plan.
These are important options for advisers as providing investments with a real choice of risk/return profiles can only add to the appeal of these products and highlight to advisers and clients the potential benefits that well designed, efficient Structured Investments can offer.
The three C’s: Client Centric Collateralisation
Collateralisation within Structured Investments is undoubtedly an important development and I would expect to see further innovations throughout 2011. Combine this additional layer of comfort with the added benefits of diversification and the result is a very compelling investment proposition designed first and foremost with the client in mind.
