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Current market conditions favour structured investment products

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The age-old advice of ‘Buy low, sell high’ makes investing in shares sound easy. Unfortunately, it is not so easy to determine when shares are low and that it is time to buy, nor what a market high is and when it is time to sell.

Currently, there is very little consensus on whether equity markets will generate good returns during 2023. Recent downgrades of global economic growth, geopolitical tensions, rising inflation and increasing interest rates add to the uncertainties when investors try to decide whether the potential return warrants the risk.

Read: Bargains? These 14 Top 40 stocks are down more than 20% since April

“The risk-reward ratio has always been critical when considering investment opportunities, but getting the balance right going into 2023 will be extremely difficult,” says Japie Lubbe of Investec Structured Products.

“The biggest risk to investment returns in 2023 remains inflation and its impact on global growth, with the possibility of a global recession. At the same time, shares seem to offer good value right now and markets are seemingly trading at around 25% below their historic average levels [measured by price-earnings ratio].”

Read:

Not where to invest, but how

“While most investors are grappling with the question of where to invest for the best risk-adjusted returns, they should rather ask how to invest for the best outcome,” says Lubbe, suggesting that the current circumstances favour structured investment products.

“History shows that equities have been, by far, the best asset class over the long term. Figures show that share markets show positive returns over any five-year period 80% of the time. The other 20% will yield negative returns,” he says.

“Investors want to be in equities when markets are doing well, but not so much when there are risks of poor performance. It therefore makes sense that protecting capital against the downside will improve returns.”

Structured products

Structured investment products aim to achieve the objectives of getting exposure to equity market returns while protecting capital.

Capital is protected by buying investment grade debt instruments, while a call option that references mainstream equity indices is used to give the market exposure.

Let’s consider how this would work for an investor who wants to invest R100 000.

A structured product will invest around 71% in a debt instrument for five years and use around 22% to acquire a call option over an equity market index. The rest goes towards costs to structure and administer the investment.

The R71 000 in the debt instrument investment will grow to R100 000 over the five-year investment period, safeguarding the original capital in nominal terms. Currently, investors will get the benefit of higher interest rates on this debt instrument for the five-year investment period.

Around R22 000 will be used to buy a call option over an index, offset by selling an option that gives away some of the upside if the market really grows strongly. Selling this option reduces the option cost and ensures higher exposure to the market up to a cap.

The structure is housed in a company, and the shares are listed on an offshore stock exchange.

“This ensures regulation and transparency in valuation,” says Lubbe.

“It gives investors a reference price and creates liquidity for instances when investors want to exit their investment before the end of the five years.

“Investec uses only banks and financial institutions with investment grade credit ratings. All the investments are done in dollars, immediately hedging against a weakening of the rand.”

Exposure to equities is obtained by buying a call option on global equity markets.

“This removes the need to try to guess which countries, sectors, industries or companies will perform well,” says Lubbe.

“The market cap weighted index automatically adjusts to include shares that are performing well and excludes the laggards. The options give us around 1.5 times exposure to equities, but the selling of an option gives away any investor gain above 60%, which is a maximum annualised return of 9.8%.”

Outcome

If markets rise over the next five years, an investor will get their original investment back from the part that was invested in the debt instrument, as well as the additional returns generated by the exposure to the market.

If markets are lower at the end of the investment term – as happens in 20% of cases – the investor only gets back their original investment.

But, Lubbe explains, the investor is in a good position to “try again”.

“If the market is 20% lower than it was at the beginning of the period, the investor still has their original R100 000. They can use it to buy shares 20% cheaper than they were five years ago. It would be a good entry point.”

Context

At the moment, investors are nervous about equities, with markets way lower than they were at the beginning of 2022.

The MSCI World Index is nearly 24% lower than at its peak in January 2022.

However, the MSCI World Index is just over 20% higher than it was five years ago – which would have given investors in a structured product a very nice return, at lower risk than a direct investment in equities.

Lubbe says a tranche of one of Investec’s structured products recently matured and it is currently structuring a new tranche.

Existing investors account for R2 billion worth of investments in this tranche, with Lubbe estimating that new investors will contribute another R1 billion by the time the current offer closes.

“Structured investment products’ popularity has increased massively during the 20 years I have been doing this at Investec,” he says, adding that it is starting to appeal to smaller investors too due to the availability of structured products on retail investment platforms.

Nobody knows what will happen over the next five years, and investors are averse to losing money.

“Investors are uncertain about markets,” says Lubbe. “Recently, estimates for global economic growth have been revised down to only 2.7%. It is not terrible, but not too good either.

“A big factor is that liquidity has been taken out of financial markets following decades of excess caused by central bank stimulatory policies. Equities look cheap and many companies have started to announce good earnings figures.”

He says it looks like a good entry point, noting that Investec has, to date, issued 181 structured investments, 101 of which have reached maturity. None have lost money for investors, and more than 90% delivered positive returns.

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