By Mickey Gambale, Momentum Wealth head of product development

Structured products have often been the topic of heated discussion with many investors adopting a love or hate relationship. When structured products first appeared in the South African retail market, investors and financial advisors alike rushed to place investments, thinking they could have their cake and eat it. In what seemed “too good to be true investments” with capital protection and market upside it was an easy decision. The result was that the majority of investors and advisors did not fully understand what they were investing into and on maturity, when the product delivered on its “payoff profile” investors were disgruntled as this payoff did not match expectations.

Structured products offer a predetermined redemption formula or payoff profile for a given maturity. This takes into account the performance of one or several underlying assets such as equities, indices, funds, etc. For example, a typical three-year equity linked redemption formula could run as follows:

• 100% capital protection with 100% participation in market growth to a maximum of 35% of the FTSE/JSE Top 40 price return index.

In laymen’s terms this means that on maturity the investor would have participated in 100% of the growth of the FTSE/JSE Top 40 price return index (if any) to a maximum of 40% growth with the benefit of capital protection should the market performance have been negative over the period.

So how is this achieved? Generally speaking the above investment product will make use of a bond (this provides the guarantee) and derivatives instruments in the form of a call spread (this provides the market upside). There is thus no smoke and mirrors and the economics of the product are fully market-related. As with any investment, it is critical that investors are fully aware of what it is they are investing into, as it is this lack of a proper understanding of the payoff profile that results in expectations not being met and the structured product then receiving criticism. Structured products are, in most cases formula based and cannot offer any payoff profile other than the one agreed on. In this way the method of calculating returns is completely transparent and investors know upfront what they investing in.

Structured products are particularly attractive for investors with specific investment periods, at the end of which they need to recover their assets for another use such as purchasing an annuity. By matching the investment period with the product maturity, assets are managed in optimal fashion during that time.

Most structured products offer capital guarantees. This feature has become so common that its importance is often overlooked. During the market crash of late 2008 and early 2009, for example, the FTSE/JSE Top 40 Index lost roughly 45% of its value. It was no small thing to be able to recover 100 per cent of one’s capital and in fact the FTSE/JSE Top 40 Index has still not yet fully recovered. Structured products with clearly identified maximum loss limits are therefore attractive to investors.

To answer the question, “Why should investors buy into a SCO product?” it is clear that the product appeals to investors who:

1. Want to diversify their portfolio

2. Want access to uncorrelated assets that improves their portfolio’s risk / return profile

3. Believe that commodities have fundamental growth opportunities that are linked to world energy, food and consumption demands

4. Want to protect their capital in absolute terms, in case of unforeseen events.

While the SCO has weathered scrutiny, the benefits, as a component within a well diversified portfolio are clear. It allows you access to the actual commodity without the red tape of a share, it provides 100% capital protection after all fees and provides for a minimum return of 40%, even if markets are only slightly positive.

Momentum Wealth’s Structured Commodity Option 1 recently returned 40% over 3 years to investors. Comparatively over the same period, the FTSE/JSE Top 40 Index returned 1% to investors and the FTSE/JSE RESI Index returned -17%.

The Momentum Structured Commodity Option 3 is now open to new investors and will close on 12 August 2011.

SCO-3, like it’s successful SCO-1 predecessor, is made up of a basket of commodities that includes base metals, precious metals, energy and agriculture commodities. It has a three and a half year investment term and offers investors a minimum return of 40%* if the commodity basket performs positively at the end of the investment term. If the commodity basket ends negatively at the end of the investment term, a 100% capital guarantee applies and investors receive their original invested capital back.

Gambale comments: “Typical investors for this product would be those that have a moderate view on a rising commodity market over the medium term. It would typically be for investors who believe that the commodity cycle is still moving up, even if moderately so, and are of the view that supply and demand for commodities over the next few years is going to lead to an increase in the price of the underlying commodities in the basket.”

Gambale adds: “This new generation structured product offered by Momentum Wealth provides investors with a ‘digital payoff’. This means that if the basket is positive over the investment term (measured from point-to-point), investors will receive a 40%* return. Even if the basket is positive by only 0.01% investors still receive a minimum 40%* return. If the basket increases above 40% investors have full participation in the upside.”

*the 40% digital return is determined on trade date.

In conclusion, portfolio construction must reflect the investor’s risk appetite and investment objectives and its contents must be understood by the investor. Structured products have a major role to play in achieving these goals in the initial construction and subsequent maintenance of a portfolio, as they can be used to address some of the typically conflicting investor wishes of capital protection and equity-type growth. Their popularity is on the increase and many studies have shown the benefits of use in portfolio construction. Structured products as an “asset class” is thus not an area anyone involved in investing or even developing client portfolios can afford to ignore.