The Role of Structured Products in Portfolio Planning

(For Professional Advisors only)

Contents
1. About this guide 2. Evolution 3. What structured products can bring to a portfolio 4. Capital protection 5. Hard protection or soft protection 6. Gearing 7. Diversification 8. Tax efficiency 9. Income 10. Difficult to replicate return options 11. About Absa Capital 12. In conclusion

Pages 1 1 2 3 4 5 8 10 10 12 14 14

1. About this guide

The aim of this guide is to provide financial advisors with an insight into the role that the current offering of structured products can play in both the creation and subsequent management of investment portfolios. The guide is designed to complement Absa Capitals A Guide to Structured Products, which explains the fundamentals of retail structured products. The guide is not a complete and exhaustive review of the risks and benefits of structured products, but it is intended to be a short summary of the main issues and benefits with regard to using structured products. Detailed risks and benefits pertaining to retail structured products are fully explained in the applicable structured product.

2. Evolution
Retail Structured Products have previously not played a predominant role in the South African (SA) investment landscape. However, with the recent increase in global market uncertainty, structured products have begun to play a significant role in investors investment portfolios. While the majority of structured products are linked to equity indices, an investment can also be structured to link to a basket of commodities or another asset class. The asset coverage offered by structured products has continued to widen, with links to international markets appearing from several providers. Innovation has continued to be a key aspect of the structured products market, as providers respond to changing market conditions and the needs of clients in a drive towards risk mitigation. The range of underlying asset classes now available through structured products underlines how far the market has moved from its early days in guaranteed stock market products.

3. What structured products can bring to a portfolio

The construction of an investment portfolio for a client involves consideration of a range of issues, including: Attitude to risk The clients risk tolerance levels i.e. how much risk an investor is willing to assume for a given level of return. How much risk is the client prepared to accept? The client will often think of risk primarily in terms of potential capital loss. Often this will be driven by recent experience rather than cold logic i.e. clients tend to be more willing to accept risk after markets have risen rather than once they have fallen. Diversification Does the proposed portfolio have an adequate spread of investments? In the 21st century the range of assets could well incorporate exposure to commodities, local and international equities, currencies, various indices, and fixed income markets. Income What income, if any, is required from the portfolio? Balancing income requirements with portfolio spread can be difficult because certain asset classes, such as commodities, may be low or nil yielding. For investors not seeking immediate income, any income generated creates re-investment issues, potential tax costs and extra administration. Timing Is there any date earmarked for capital requirements, for example a planned retirement? A definite realisation date can constrain portfolio structure by limiting exposure to more volatile assets and placing greater emphasis on fixed interest securities. Tax efficiency While the tax tail should never wag the investment dog, deciding on an appropriate form of investment for each asset is undoubtedly part of portfolio construction. With current capital gains tax legislation allowing an annual exclusion of R17,500 per annum for a natural person, a structure such as a Long-Equity Investment Plan (LEIPS) may provide an added tax advantage to a structured product investment in the investors portfolio. The current capital gain tax rate is a maximum of 10% for a natural person, which is significantly lower than income tax rates which range between 18% and 40% depending on the investors tax bracket. Hence, an investment in a LEIPS structured product could provide a more tax efficient solution by potentially making the return subject to capital gain tax rather than income tax. These factors can all be addressed through structured products: Attitude to risk Capital protection and features such as capitalising on non-directional market plays can limit the risk of capital loss and increase the probability of returns. The protection can also help counter any aversion to investment in difficult market conditions and, at the other end of the scale, protect against over-exuberance when markets are strong. Diversification The wide range of links available through structured products offers a useful tool for diversifying portfolios, particularly in the more specialist asset areas such as international markets. Income Structured products can be used to provide income from virtually any asset class. However, if income is not required, then it can be absorbed into the product design and reflected in overall returns.

Timing Most structured products have specific maturity dates, commonly in the three to six year range. The fixed term nature of these products has been, for some advisors, a point of contention. However much has been done to improve the accessibility to structured products during the life-cycle. It is now often possible to redeem the product early, although there may be penalties. Tax efficiency The framework of a structured product can usually be chosen to provide tax efficient returns. For example, products with the same underlying asset could deliver more tax efficient returns depending on whether the product is geared to provide normal investment returns subject to income tax or capital gains tax returns (as may be the case with a LEIPS product). These aspects of structured products are explored in greater detail throughout this guide.

4. Capital protection
The volatility seen in virtually all markets throughout 2008 has had an inevitable effect on the psychology of many investors; an element of capital protection is now likely to be more welcome than in the past. The capital protection given by structured products can provide a floor level for a portfolio. For example, if 60% of a portfolio is invested in structured products with 100% protection, it could be argued the effective maximum loss exposure is 40%. Capital protection can allow a low risk portfolio to incorporate a broader range of assets than might otherwise be the case. For instance, it is easier to expose part of a cautious investors portfolio to equities or commodities through a structured product which limits or removes completely the downside risk to capital. While capital protection is a key feature of virtually all retail structured products, the level and degree of protection varies between structured products: there is no universal standard. Thus, advisors must examine each product to ensure that they and their clients understand what protection is being provided as well as its effect on investment returns. Protection is not guaranteed. If the counterparty providing the underlying investment of a structured product defaults, then the protection may be lost. The choice of structured products for a portfolio must take into account the strength of counterparties and their ability to repay the clients money. Protection has a cost. As a general rule, the higher the level of protection, the lower the potential upside. This becomes obvious when a product provider offers two products which are identical except for the level of capital protection (e.g. 85% vs 100% of original investment). The corollary is that a portfolio should only incorporate protection to the extent it is required. Protection can be either hard or soft as explained on the next page.

5. Hard protection or soft protection?

Hard protection Hard protection fixes a floor below which a structured products maturity value is protected, regardless of investment conditions. Many growth plans offer 100% hard protection, i.e. investment on a money-back basis. However, accepting even just a slightly lower level of hard protection (say 95%) can significantly increase exposure to the underlying asset. For example, on a five year FTSE/JSE Top40 Index-linked plan foregoing five percent protection could increase returns by 20% of any growth in the index. Soft protection Soft protection is a more limited form of protection. The maturity floor which it sets only applies if the asset class does not fall below a safety barrier level. A typical example would be that full capital protection would apply provided that the underlying asset does not fall by more than 50% at any time during the products term. If that barrier is breached, then the maturity value is reduced by one percent for each one percent the asset value at maturity is below its initial value. For instance, if the asset maturity value is 80% of the initial level, then soft protection provides a maturity value of: 100% if the asset value has not fallen by more than 50% at any time 80% otherwise

Soft protection is the more cost effective option, meaning it offers potentially higher returns, but there is also a greater risk of loss to both capital and the return, particularly in extreme market conditions.

6. Gearing
Portfolios for private investors rarely incorporate any explicit form of gearing, whether in the form of borrowing to finance additional investment or the use of derivative contracts. Underlying investment funds used in portfolio construction - particularly hedge funds - may include such techniques, although there are strict limits on the borrowing possible within Collective Investment Schemes (Unit Trusts). Gearing is usually avoided in private investor portfolios because of the additional risk it creates. A return of twice that of the underlying asset return is attractive when values are rising, but losses are magnified when the prices are falling. The 2008 experience of some professional investors has underlined the risks. Structured products with capital protection allow gearing to be introduced into a portfolio with defined limits placed on the corresponding downside. However, the higher the gearing, the more likely it is that the total return will be capped. 5

Geared structured products have several useful roles in portfolio planning: If returns from an asset class are expected to be positive, but not substantially so, a structured product can be used to amplify those returns. The ultimate form of gearing is the digital structured product. A typical digital product gives a fixed return (e.g. 40% after five years) provided the relevant index at the end of the term is not below its starting level. Where the threshold is not met, normally there would be 100% capital protection. The digital plan is best suited to those situations where returns from an asset are expected to be close to flat. Gearing can free up capital for investment for other areas or provide additional liquidity. For example, if a 30% exposure to South African equities is required, then only 10% of the portfolio need be invested if the chosen structured product has 3:1 gearing to the FTSE/JSE Top40 Index. The mechanics of a geared structured product often effectively mean that income is being exchanged for faster capital growth. This can be advantageous for high tax paying investors (see Tax Efficiency).

Case study I: Putting gearing to work

The client Pieter has a R6,500,000 portfolio from which he has been taking income withdrawals of R200,000 a year for the last three years. Dividends from Pieters company provide the bulk of his income; the withdrawals are his disposable income. The problem Pieter takes an active interest in his portfolio and has a meeting with his advisor every six months to review his portfolio of investments. At the last of these meetings, Pieter and his advisor discussed at length the schemes 30% exposure to the FTSE/JSE Top40 Index. This was structured with a core of tracker funds surrounded by specialist satellite funds. Pieter and his advisor agreed that for the next few years the outlook for the South African stock market was for difficult conditions. Nevertheless, both agreed the exposure should be maintained.

The solution The advisor recommends that the tracker funds forming the core of the SA equity holding should be replaced by a four year Accelerator product. The benefits of this approach: The core would have a 400% geared exposure to the FTSE/JSE Top40 Index, giving a maximum potential return of 50% if the Index has risen by 12.50% or more in the next four years. If the Index falls over the next four years, there is 100% soft capital protection with a barrier level of 60%. The Accelerator is linked to the FTSE/JSE Top40 Index rather than the JSE All-Share Index. As the satellite funds are mostly at the small cap end of the market, the end result is a closer match to the overall South African market than the current structure. A modest market performance favours the Accelerator, as does an Index fall of more than the net dividend yield. The Accelerator produces no income and is likely to be taxed as capital gains due to the LEIPS wrapper, thereby producing a tax efficient return for Pieter who is a higher rate tax payer.

Barrier

Payoff

Index

50% Capital Protection -40% 12.50%

Cap

Underlying

Source: Absa Capital

7. Diversification
Diversification is one of the key principles of portfolio construction. The fact that diversification can be used to improve the risk/reward ratio is one of the main conclusions of modern portfolio theory, which underpins the basis for much proprietary asset allocation software. In practice: There is diversification between different asset classes. This was historically limited to three or four asset classes - domestic/international equities, fixed interest and cash. There is no commonly agreed number. Commercial property and commodities would now appear on most asset allocators lists, while other classes, such as infrastructure and hedge funds, are becoming norms for institutional investors to consider. Within each asset class diversification is also required. Often the starting point for this is an appropriate index. For example, US equity asset allocation is commonly benchmarked against the S&P 500 Index. For private investors, diversification within the traditional asset classes is usually achieved by the use of Collective Investment Schemes (CIS). Collective Investment Schemes can also provide access to some of the new asset classes, although the choice of funds and track records tend to be limited. Structured products play a variety of roles in providing a means of diversification for a portfolio. Most structured products have an index as the underlying asset, which means that diversification within the asset class is automatic. A structured products index-linking is not subject to any tracking error, although it must be borne in mind that many structured products use averaging when setting final values. The range of underlying assets for structured products includes areas which are not easily accessed via Collective Investment Schemes e.g. certain foreign markets or commodity-linked products. In addition, underlying asset classes like inflation and hedge funds suddenly become accessible in packages which reduce risk or gear up returns. Although diversification is generally recognised as a risk-reducer, it does not eliminate all risk. In extreme market conditions - such as those seen worldwide in the second half of 2008 - the benefits of diversification can largely disappear in the flight to safety. Under such circumstances, the capital protection offered by structured products can play a valuable supporting role alongside diversification. 8

Case study II: Commodity exposure

The client Annemie is a successful lawyer who has just inherited a substantial lump sum from her grandfather. She wants this to be invested in a broadly diversified growth portfolio. The problem Annemies advisor wants to build some commodity exposure into her growth portfolio. However, he does not want to use funds which invest in shares of commodity producers because of the companies volatility and political risk. He would prefer to have direct exposure to a broad range of physical commodities. The solution The advisor decides that the commodity exposure in Annemies portfolio should be achieved via exposure to a commodity basket with a structured return. The use of this structured product has the following advantages: The product gives exposure to a fixed basket of precious metals (five percent), base metals (22.5%), agriculture (15%) and energy (57.5%). The commodity weightings are determined by Absa Capital, not an index provider. For commodities, the use of indices does not always provide adequate diversification between sectors. For example, the widely used S&P GSCI index has a 71.80% weighting to energy, including over 37.50%* to crude oil. The product gives 100% exposure to the commodity basket performance over five years, subject to a maximum return of 100%, with performance averaged on a monthly basis over the final year. There is 100% hard capital protection at the end of the term. Earlier withdrawals can be made on a fortnightly basis, with the amount payable determined by the price of the underlying investments realised. No protection applies to early withdrawals.
Source: Absa Capital

Payoff

Commodity Basket

100%

Cap

Capital Protection 100% Underlying

* As at 30 April 2010 9

8. Tax efficiency
Generally it is tax efficient for investment returns to be in the form of capital gains: For the 2009/10 tax-year there is an individual annual exclusion for the first R17, 500 of capital gains. There is a 25% inclusion rate on capital gains earned above the annual exclusion mentioned above which at a maximum individual tax rate of tax of 40% would result in a maximum tax charge being levied of 10% (25% x 40%).

There is also the benefit of being able to defer capital gains to the disposal date of the asset, whereas a liability to income tax on normal investment income may result in taxation being payable at a much earlier date as and when the investment income is received or accrued. Structured products are often able to provide investment returns in the form of capital gains, even in those rare cases where an underlying asset incorporates re-invested income (e.g. accumulation units in Collective Investment Schemes). Through Absa Capitals LEIPS structure, it is possible to earn investment returns in the form of capital gains which are more tax efficient.

9. Income
Just as structured products can be used to convert income into prospective growth, so they can also switch from potential growth into immediate income. Thus a structured product can offer an income yield well above that of the underlying asset with a capital protected return of the original investment. For example, it would be possible to have a product linked to the FTSE/JSE Top40 Index that could offer 10% annual income over four years against a yield on the index of 2.08% p.a*.
*As at November 2010

The ability of a structured product to boost an assets underlying income has three main benefits in planning income portfolios: It provides a fixed amount of income for the structured products term; It allows part of a portfolio to be invested in an area which might otherwise be considered inappropriate because of its low yield and; It avoids the need to make regular capital withdrawals to supplement dividend or other income.

10

The exchange for the additional income is that the investor will not receive any growth in their capital and could suffer a loss. Income plans normally have soft protection with a barrier level such as 50% to 60% of the strike price. Thus at maturity there would be a capital loss if the barrier has been breached and the index has not fully recovered.

Case study III: Income underpin

The client Vusi is nearing his 60th birthday and is just about to retire as the senior partner in a small law firm. He has a substantial investment portfolio, part of which is invested directly and part through a Living Annuity. The problem Vusi wants his Living Annuity, currently valued at R5,400,000, to provide minimum income withdrawals of about R200,000, a year for the next five years, at which point his state pension begins. The Living Annuities current investments are a mixture of South African and international equity funds. The solution Vusis advisor recommends that the South African element of the Living Annuities investments, amounting to R2,400,000 are switched to a Regular Income Product that pays out seven percent p.a. in quarterly instalments. By replacing the South African holdings with this Product: Vusi maintains an exposure to South African equities as the underlying index for the Plan is the FTSE/JSE Top40 Index. An income payment of R42,000 per quarter (R168,000 a year) is generated. This means the balance of the portfolio need only produce a net yield of R32,000 - a yield of 1.06% - for Vusis R200,000 minimum to be reached. The residual portfolio already provides more than this. The Plan matures after five years, when Vusis state pension begins and there is a five yearly review of the Living Annuity drawdown limits. There is 40% soft capital protection. If, during the life of the Plan, the FTSE/JSE Top40 Index falls by more than 40% from its strike level and is below the Initial level at maturity, the R2, 400,000 original capital will be reduced by one percent for each one percent that the maturity index level is below the strike level. Vusi is already exposed to such potential losses with his existing South African holdings, but with no 40% barrier of soft protection.

11

10. Difficult to replicate return options

An unusual profile of investment returns is one of the often ignored advantages that structured products can bring to a portfolio. Some of these more complex types of structured products only appear when market conditions produce a suitable pricing of the underlying derivatives. The variations, which are many and increasing, include: Bull bear structured products, sometimes called straddle growth, offer a geared return based on the absolute movement of the underlying asset price, subject to lower and upper barriers. For example, a plan could offer 130% of the absolute change in an index, provided that barriers of -40% and +40% are never breached during its term. The maturity value is restricted to the original investment if either barrier is crossed.

Payoff

Index

Digital plans can produce relatively highly geared returns in dull markets, providing the asset value at maturity is not below the strike level. Best of structured products provide a return based on the best performing component of an asset basket, e.g. the highest performing of the FTSE/JSE Top40, FTSE/JSE SA Listed Property and the FTSE/JSE Industrial 25 Index. There are also worst of versions. Kick-out or knock-out structured products are fixed term products which automatically mature early if a certain level of asset performance is achieved by a given date (usually a plan anniversary). Where an advisor has a particular view about a market, these types of structured product can be used to reinforce the potential returns from that judgement.

130% Participation -52%

-40%

40%

Underlying

Source: Absa Capital

12

Case study IV: Kick-out

The client Lerato would like her advisor to review the SA equity element of her portfolio, as it has produced disappointing returns in recent years. She is also concerned about potential future losses. The problem Leratos advisor agrees that the performance has been poor, but thinks that continued losses might be the order of the day, at least in the short term. However, he does not want to reduce Leratos exposure to SA equities: they are a core part of her portfolio and the market could always produce a surprise. The solution After reviewing her holdings, Leratos advisor suggests that a few of the more specialist holdings are retained (e.g. small companies); but that approximately 75% is invested in a FTSE/JSE Top40 Annual Kick-out product. He explains the benefits to Lerato as: The product is linked to the FTSE/JSE Top40 Index, so she is retaining exposure to the SA equity market. There is 100% capital protection at the end of the products four year term, provided that the index has not fallen by more than 50% during its term. If it does fall by more than 50%, and is below the Initial level at maturity, the capital will be lost by one percent for every one percent below this level. The product has a kick-out option which triggers an automatic early maturity if the index is at or above its starting level on the anniversary of the trade date. For each year the product is in force, there is a 10% simple return. Thus, if the products early maturity is triggered after three years, the total maturity payment would be 130% of the initial investment. As the kick-out would occur on any anniversary when the initial level was exceeded, this would allow Lerato to reinvest directly in funds in an improving market.

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Early redemption Year 1

12. Conclusion
In the world of Treating Customers Fairly, portfolio construction can no longer be a black art which magically produces a mix of funds for a client. The portfolios construction must reflect the clients goals and its contents must be understood by the client. It is equally the case that a portfolio cannot be a fixed structure. It must be regularly reviewed to take account of changes in the clients circumstances, investment conditions and new investment opportunities. Structured products have a major role to play in achieving these goals in the initial construction and subsequent maintenance of a portfolio. Structured products can: Address some of the typically conflicting client wishes for capital protection and equity-type growth. Offer exposure to asset classes which are otherwise difficult to access. Provide tax efficient solutions for both income and growth. Produce geared, reverse and other types of return for different asset classes. Form a core index-tracking holding in a core/satellite structure. Reduce administrative burdens by avoiding the issue of income reinvestment.

Is FTSE/JSE Top40 at or above strike?

No

Yes

110% - early redemption of the product 120% - early redemption of the product 130% - early redemption of the product 140% - early redemption of the product 100% of the initial investment Par - fall investment

Year 2

Is FTSE/JSE Top40 at or above

No

Yes

Year 3

Is FTSE/JSE Top40 at or above

No

Yes

Year 4

Is FTSE/JSE Top40 at or above

No

Yes

Has the 50% Barrier been breached?

Source: Absa Capital

No

Yes

11. About Absa Capital

Absa Capital prides itself on its ability to produce high calibre, cost effective investment solutions. Absa Capital works closely with financial advisors to develop the award winning proposition to become South Africas leading supplier of retail structured products. Absa Capitals success stems from the belief that the customer should be at the heart of the proposition. All of Absa Capitals investments are designed in collaboration with financial advisors to ensure clients have ready access to product that suits their personal requirements. 14

Structured products are at the leading edge of retail investment design. Many of the most innovative products to be launched in recent years have been structured products or had structured product components included. This is not an area anyone involved in developing client portfolios can afford to ignore.

Tel: +27 (0)11 895 5528 :: 15 Alice Lane, Sandton, 2196, South Africa :: http://www.rsp.absacapital.com/

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