Beware the vast majority of structured investment products that are offered around the Irish market; they exist to serve the sellers and, in the main, are poor-value investment products for consumers. And they are tricky products to understand, which is why many investors can be seduced into them. We hope this Featured Article assists you to better understand why we recommend that investors avoid them.
As an example, we might take the recent European Index Kick-Out Bond constructed by Societie Generale bank and sold in Ireland through intermediaries and brokers with a closing date of 30th May 2017. The minimum investment was €20,000. There was a 100% capital guarantee under certain circumstances and the suggestion of a potential 10% per annum return over a six-year period.
In our view, the downside risks and/or opportunities foregone elsewhere are almost impossible to determine, and the product is inferior to a similar €10,000 investment into Eurozone equities (via a low-cost ETF) and €10,000 into bank deposits, a more straightforward approach to investing that will lower costs and most likely lower risk for investors.
The attributes of this European Index Kick-Out Bond in more detail include:
- This underlying index is an equal-weighted Euro Stoxx 50 Index that pays out a constant 50 ticks by way of a dividend annually, or a 4.54% dividend yield on today’s index price of circa 1,100. This dividend income stream is not received into the structured product, but is used to fund the capital guarantee, to underpin a portion of the potential annual returns and cover costs.
- There’s a 100% capital guarantee, so long as the Euro iStoxx EWC 50 Index is not down 40% by the final maturity date in six years’ time.
- If at any anniversary date the Euro iStoxx EWC 50 Index is at or above the initial level, the investor can get a 10% annual return for each year that has passed since the initial investment was made. If that return is delivered in year one, the investor is redeemed with the 10% return. If not, the product remains in play and redemption then happens at end of year two with a 20% return delivered; rising to a potential 30% return after year three and up to a maximum return of 60% if not redeemed until the end of year six.
- The product is a security and your counter-party risk is Societie Generale. Any gains are paid out without any tax deductions. It is unclear whether the product is subject to capital gains tax (33%) or dirt tax (41%).
- If at the end of year 6 the Euro iStoxx EWC Index is down 40% or more the investor suffers this loss. Losses between 1% and 40% are covered by the capital guarantee.
- Costs at the intermediary or broker end are disclosed as 1.5%, but investors should understand that there are costs at the investment bank end for the construction of the product, although it has not proved possible to determine the level of these ‘construction’ costs.
What’s your initial reaction – perfect product, perhaps? But common sense should alert you to the fact that – like most areas in life – there’s no free lunch in markets. As the underlying equity index can only deliver a certain level of return, costs are an important element to consider by investors and such a lack of clarity in this structured product (and others) is a distinct negative, in our view.
First off, you are invested in the Euro iStoxx EWC 50 Index, which is an equal-weighted version of the Euro Stoxx 50 Index, and you are surrendering the 4.54% dividend income stream from this index, which is worth 27% over the 6-year term of the product.
In year one, if the Euro iStoxx EWC 50 Index is at or above the initial level, you’ll get a 10% return. But what if the index rises 20%? You’ll get the 10%, but will be ‘kicked-out’ at that stage and you’ll have missed the extra 10%. No doubt, you’ll then be offered a similar product to reinvest in, but the markets are now 20% higher – so the risks have risen and you’ve missed much of the gains.
If markets are not up in year one, you are still in the product. In year 2, markets will have to recover to or close above the initial index level, and then you’ll get a 20% return.
Roll forward to year 6, and assume that markets have been down for the full 6-year period, otherwise you’d have been ‘kicked-out’ in year 1, 2, 3, 4 or 5. They must rise to or close above the initial level in year 6 to get the 60% return. But the chances of investors not having been kicked out along the way are remote. All the while, you have surrendered the dividend income flow – worth 27% over this six-year period.
You are exposed to any loss of 40% and more over the six-year period. Given that the dividend pay-out over the period is 27%, this is not as small a risk as it may appear at first glance. And if the risk does crystalise, you are kicked out and your loss is permanent. In contrast, if you own Eurozone equities via a standard fund – like an exchange-traded fund, an investment trust or a life company fund – you own the asset and any loss is likely a temporary one, as you have every chance of recovering your loss as markets recover in time, as they inevitably do.
Over all, it’s near impossible for anyone other than professionals in investment banks to price the risks and opportunities lost in a product like this. Yet, you are the bookie in this situation and you will take the loss if it occurs. The other parties – the product manufacturer and distributors – know how to price these products, but the full costs cannot be determined by an outsider such as ourselves. Elaine, a senior investment adviser with GillenMarkets, sums it up well when she says “investing in such products is akin to making bets“.
But what if you are a more conservative investor and like the sound of a 100% guarantee? Well here’s a simple alternative for you, and one you can more easily understand. What if you invested just €10,000 in Eurozone equities via a low-cost ETF and placed the remaining €10,000 into bank deposits earnings 1%.
The following table highlights your returns profile after six years if you just received the 1% interest on your bank deposits and the dividend yield from the Eurozone equity markets, which are providing an initial dividend yield of 3.3% (and we will assume that this dividend grows at 4% annually from here). The table also highlights the impact on you if the Eurozone equity markets are down 40% at the end of an equivalent 6-year investment term.
For the sake of simplicity we will ignore taxes. Your bank deposits have rolled up to €10,615 and your Eurozone ETF investment is now worth €12,503 – made up of the initial €10,000 investment plus dividends received. Your initial capital of €20,000 is now worth €23,119 for a 15.6% return, and we have assumed no capital growth. If we assume that the Eurozone equity markets are down 40% at the end of the six-year period your investment is worth €19,119 for a 9% loss.
You have to ask yourself; even as a conservative investor, do you really need a capital guarantee? Isn’t the correct question more along the lines of; from my saving of €20,000, how much should I keep in a non-risk asset like bank deposits and how much in a risk asset like Eurozone equities?
Now let’s look at the possible upside. Eurozone equities look capable of delivering the dividend plus capital returns of, say, 5% per annum with the capital growth reflecting the growth in underlying earnings at the 50 companies in the index (or fund).
In this more realistic scenario your return works out at 36% at the end of the 6-year period (again taxes are ignored for the sake of simplicity). That’s below the maximum that you could possibly obtain from the European Index Kick-Out Bond. But, in our view, we would attach a very small probability to investors obtaining the potential 60% return as highlighted in the product’s brochure, and a much higher probability of obtaining the 36% return.
Tax due (CGT or Dirt tax) becomes payable no later than at the end of year six – when deemed redemption kicks in – whereas in our example you can hold the Eurozone ETF for the long-term with no capital gains tax crystalising, or at least you can with a non-EU regulated Eurozone ETF.
We come across these products all the time from the banks, insurance brokers, other intermediaries and the private client stockbrokers. In our view, they exist to reward the sellers and we cannot see how anyone can argue that they are in the best interest of clients. What we would hope is clear from the above analysis is that anyone offering you the above product types are not advisers, but sellers. An adviser should recommend that you own the asset, and to only invest that amount of money you are comfortable with knowing the potential downside risks. In our view, such structured products carry greater costs than the more straighforward strategy outlined above of splitting your capital between bank deposits and low-cost equity exchange-traded funds as well as potentially exposing investors to ad-hoc permanent losses.