Just one part of the portfolio

The argument for structured products is as simple as it is valid – they provide certainty by giving exposure to a rising market while defining the potential loss. As such, they can play an integral part in a portfolio’s broader investment strategy providing them with a known downside outcome.

In this example, we assume an investor is bullish about the share market’s potential, but the memories of the GFC are still fresh in his memory; he wants to safeguard the bulk of his capital. For such an investor, a structured product can be a good solution – and here’s how it can work.

Assume the investor has a $500,000 portfolio, a three-year timeframe, and wants $200,000 worth of exposure to Australian equities. After discussion with his financial planner, agrees the ASX200 has the potential to reach 6500 in three years – but could trade as low as 4000 over that period.

The upfront cost of gaining exposure worth $200,000 of exposure is the interest cost of $13,100, leaving the bulk of the client’s portfolio, $486,900 in defensive assets. Assuming a 5% total return, this defensive sum will be worth $511,245 after 12 months.

So what is the actual cost of the product?

In this example, the investor pays $13,100 for three years; however the structured product also pays a fixed coupon of 4% so the investor would receive $8000 of income at the end of year one. Thus the next payment by the investor in year two is $5,100 ($13,100 - $8,000 = $5,100) which is paid at the beginning of years two and three. This makes the total paid over the life of the investment $13,100 + 2 x $5,100 = $23,300.

So what’s really happened here? The investor has obtained $200,000 of exposure to the Australian stock market by risking $23,300. They have retained over $480,000, which could grow to $552,699 if the defensive assets continue to provide total returns of 5% a year over a three-year period. This can provide the investor with a strategy with a known downside outcome. i.e. They could lose a maximum of $23,300 over three years.

Assuming the stock market does reach 6,500 in three years, from current levels of around 4950, it represents a 31% gain. In this example of a structured product the two 4% coupons are deducted from this gain and the total gain is 22% (33% - 8%), or $44,000.

No doubt the other question to be asked is: what is the break-even point?

That can vary quite significantly from client to client and the strategy employed. The strategy in this example produces a positive outcome for clients even if the stock market doesn’t perform as the majority of his assets are invested defensively producing its 5% total return.

But assuming none of these factors are present, the break-even point on the structured product alone and not the strategy is 6.55% a year. If you are bullish about the Australian share market, that 6.55% a year is certainly achievable and below most clients’ plans – and you have only put about 5% of the investor’s portfolio on the line to achieve a 40% exposure to equity markets.

About Gabriel Carey

Gabriel Carey is Sales Director at Instreet. He has over 12 years’ experience in the financial services industry, with skills in designing, structuring and distributing financial investments.

Gabriel was previously Southern Regional Manager for Macquarie's Funds Management Group, director of a private equity fund and spent five years as National Marketing and Distribution Manager for Rural Funds Management.

Before commencing his career in finance, Gabriel spent 10 years as an Officer in the Royal Australian Air Force.