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Structured products: A case of apples and pears

Date: Monday, October 26, 2009
Author: Money Management.com

As the end of each financial year approaches, institutions offer structured products as a way to lower tax. Attractive as that sounds, it’s simply not that easy. Often it’s an apples and pears argument when comparing structured products and their after-tax returns.

But how do we assess the plethora of product? We believe the first key to comparing these structured products is to understand the maximum loss, due to market moves. Understanding the underlying market move to generate the break-even internal rate of return (IRR) after-tax for the structured product is the next step. Simplicity counts when it comes to understanding break-even IRR and the expected IRR of a structured product. The more complicated the structured product, the more difficult it is to do an IRR calculation. Let’s outline some rules of thumb that can help analyse and compare structured products quickly.

It is important to understand the tax, counterparty risk and whether the structured product is suitable for self-managed super funds (SMSFs) or individuals. If there is an investment loan, what are the associated break costs and the recourse associated with the loan? Loans with full recourse to the investor may have a different tax treatment than loans with no recourse to the investor.

Maximum loss, due to market moves for many structured products is zero, as they are capital protected. This, of course, does not take into account the counterparty risk, the risk that the issuing institution will not be there when required to meet the obligation to repay your money. When we discuss maximum loss or break-even IRR analysis we are concerned with the loss caused by the underlying market moves, not the counterparty risks.

Many investors at this time of year borrow up to 100 per cent of the investment amount to purchase the structured product and prepay the interest. In these cases the maximum loss are the interest payments. If you are paying 8 per cent per annum for a five-year product on a $100,000 investment, then the maximum loss would be 40 per cent or $40,000. This is the worst case scenario before tax. On an after-tax basis the worst case should be less, depending on the applicable tax treatment. Structured products with investment loans that have low after-tax running costs will perform the best when examining this worst-case scenario.

Interestingly, the break-even after-tax IRR can give a significantly different result than the maximum loss analysis. Structured products with low after-tax running costs can still have high break-even IRR.

For a 100 per cent capital protected product, the break-even IRR should be 0 per cent, as you should get your initial investment back even if the market falls. For products with 100 per cent investment loans it is easy to approximate the after-tax IRR. These structured products are usually treated on ‘revenue account’ for tax purposes to get the deductions.

As a rule of thumb, the after-tax break-even IRR is the interest rate that is paid to fund the investment, less any guaranteed distributions. Distributions that are at risk usually do not affect the break-even IRR, so it is still just the interest rate paid to fund the investment. The reason that the interest rate is a good guide for break-even IRR is that the returns from the product are taxed at the same rate as a deduction received on the interest. Therefore the tax rate does not come into the calculation of an IRR for a structured product with a 100 per cent investment loan where the gain from the product is on revenue account.

Some structured products have a ‘barrier event’. This occurs when the market falls significantly causing a loss of capital. This event can vary from product to product and ranges in market falls from 15 per cent to 40 per cent. In these cases the after-tax break-even IRR can be low or even negative as they pay a yield if the market remains above the barrier.

Advisers need to be comfortable with the risk of the barrier event occurring, so that the benefit of the low break-even IRR offsets the risk of the market triggering the barrier. The maximum loss on these structured products can be higher and less defined than the 100 per cent investment loan, capital guaranteed structured products.

To compare structured products, the maximum loss and the break-even IRR analysis are a good starting point. Products with low break-even IRR will add value faster to a client’s portfolio than a similar structured product with a similar market exposure but a high break-even IRR.

The break-even IRR for the above example is 8 per cent per annum, as this is the interest rate. The maximum loss is 40 per cent or $40,000. We would therefore require the underlying market to grow by more than 8 per cent per annum if we expect to provide a positive return to our clients. If the market doesn’t perform, the investor could lose $40,000 before tax.

For structured products that do not have 100 per cent investment loans, but an investment loan of 70 per cent, for example, the investor is required to pay some collateral or an initial investment upfront. In these cases, the break-even IRR will be higher than their interest rate. The maximum after-tax loss may also be higher if the collateral or initial investment is at risk and the investor could lose the initial investment.

If the structured product has a capped return, then you can also calculate the maximum after-tax IRR. To calculate this IRR, divide the maximum gain by the maximum cost. The maximum gain would include dividends. If, on the example above, the product has an 80 per cent cap then the maximum return is 80 per cent or $80,000. The maximum cost is $40,000 for the example above. So the maximum IRR is 80/40-1 = 100%.

The structured product is a five-year product in this example, that will translate into a 14.9 per cent per annum maximum IRR after-tax. As a cap can reduce the cost of a structured product, the maximum IRR can be significantly higher than the underlying market move needed to achieve it.

For structured products like CPPI or Volatility Targeting, where the structured products do not track the underlying market moves exactly, it becomes more difficult to determine the after-tax break-even IRR. For these it is possible that the underlying market will grow more than the break-even IRR, yet the break-even IRR is not achieved.

This can make the comparison analysis more difficult, as an 8 per cent per annum move in the underlying market may not necessary translate into an 8 per cent per annum increase in the final NAV of the product to offset the interest rate expense. In these cases the adviser must decide if the product will achieve its break-even IRR.

Individual clients have specific requirements. Not all of them meet by the variety of structured products. Advisers need to consider the client’s portfolio and financial needs when recommending structured products. Structured products are increasingly being used to re-weight portfolios to growth assets, provide protection while maintaining participation to the market, or even more sophisticated strategies that take profits for the current rally off the table and then use structured products to maintain participation, managing the upside risk if the market continues to rally. Whether they are used in an SMSF or for individuals as an accumulation strategy, the same risk-management concepts that are used to construct a portfolio still apply.

Getting your head around some of the complexities and features of structured products can be a slow process. With the application of the principles and rules of thumbs for IRR and maximum loss outlined here, the task at hand can be made less daunting. It may become as easy as learning about the difference between a Jonathon and a Golden Delicious apple.

George Lucas is managing director of boutique asset manager Instreet Investment.