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Thinking outside the defined returns box

We have recently seen one of our defined returns products kick out.

On 26 July 2016 we set up an investment with Societe Generale (Soc Gen) when the FTSE 100 was at 6,724 (called the “strike” level). This investment promised to pay a pre-defined return of 9.6% should the FTSE be at or above this level on its first anniversary.

On 26 July 2017 the index closed at 7,452 and so the product ended on this date providing the promised gain. Had the market been down over the first year it would instead have rolled on to the second anniversary, then potentially the third and so on for six years. If the FTSE was down over the full six years the product would have returned the initial capital, unless the market had fallen 40% or more by that particular day.

Over the period the Soc Gen product was “live”, the FTSE was up 10.8% in price terms which is around 15% factoring dividends into account. We would therefore have seen better returns had we bought an index tracking fund instead. Of course, this would have come with more risk (at least in terms of market risk) since we would not have the element of capital protection or the potential for such returns to come from a sideways, rather than upward, market.

We have been planning for this kickout for some time and have analysed several potential re-investment strategies.

The options we considered included setting up a new defined returns product with a similar structure. We would potentially have been able to obtain a rate of perhaps 8.5% for the same type of product, so well below the return we received from Soc Gen. Of course, setting up a new product now would also be at a much higher starting level for the FTSE 100 Index.

When we look at those two factors we feel that the risk was higher than when we had set up the Soc Gen product and the potential return was lower. We feel that stockmarkets look expensive and the risk of a sharp correction has increased.

There is another type of structured product called a “defensive autocall” which is a variation on the above theme. Again, it has a fixed period of up to six years with potential kickouts on anniversary dates. The difference is that the level at which kickout would occur reduces each year.

For example, if we set up a product at 7,400 on 1 August 2017, the product would kickout if the FTSE was above 7,400 on 1 August 2018 (100% of strike level). However, at the second anniversary it would kick out at 95% of strike (7,030), then 90% in year three, 85% in year four, 80%, year five and 75% in year six. This means the product would still provide the return even if the market was above 5,550.

This is an attractive structure but of course the more defensive nature means the potential return is lower. If we set up a product directly on the FTSE 100 then we’d probably expect the rate of return to be around 6.5% pa. This isn’t an attractive enough return in our view, given the risk.

However, we have recently met with a fund manager who operates a fund of these products. The Atlantic House Defined Returns fund is run by some ex-Citibank traders who used to set up such products for the bank.

A structured product is usually offered by a bank who in the background uses a combination of equity options and bonds to provide the return.

The Atlantic House fund can essentially structure their own product by using options directly and holding gilts as collateral. This means they can cut the banks out of the loop and achieve potentially higher rates of returns than a traditional structured product.

The fund aims to provide 7% to 8% pa over the long term, although  this is not guaranteed. We feel this is an attractive potential return and comes with less market risk due to the defensive nature of some of their structures. There is also less counterparty risk with the fund than a direct structured product linked to the credit of a single bank.

The products within the Atlantic House fund give greater diversification of exposure to different regions, and also diversification of potential anniversary dates.

We have therefore decided to reinvest the Soc Gen proceeds into this fund. For most clients this is around 2% of their portfolios.