GUARANTEED' PRODUCTS - MYTHS & REALITY

12.10.2003

Globally, in the last three years, 'structured' guaranteed products appear to have come into their own; pushing aside the traditional equity offerings, mutual funds, and for that matter, even bonds and bank deposits in their wake. Suddenly, products per se have taken precedence over plans or portfolios managed or over the diversification afforded by mutual funds and collective investment schemes. Understandably, customers, who have been severely battered during the bursting of the technology bubble and then the sharp slide in the equity markets, retreated into the shell of capital guaranteed products and are only now beginning to slowly venture out into anything remotely resembling equities. It is not just the pervasive stock market aversion that caused this shift or the huge unrealised losses that both institutional and individual investors were sitting upon in the yesteryears. The customer confidence has also been undermined by the spate of scandals, whereby the implicit trust that was there in globally reputed institutions and their disclosed financial statements, the periodical research reports they produced, have all suffered a serious loss of credibility. For this, the professionals are to be blamed - the accountants, the auditors, the CEOs, the managers and the research analysts, in the investment banks and MNCs and indeed, the so-called set of skilled and trained graduates in management, finance and analytics - all have added to the woes of the investor community

Thus, a whole of host of professional and non-professional investors have taken refuge in the comfort of the guarantee of reputable institutions, which atleast establishes a floor for recovery of money i.e. they will not 'ostensibly' lose money, even if they do not make profits. Cashing in on these trends, and using the gamut of financial engineering derivatives (the dreaded D word) and sometimes, through some clever opaque 'structures', the market is now flooded with a plethora of guaranteed products.

Intelligently or even intellectually, it is difficult to challenge the conceptual or the creativity that underlie such structures. They do serve a purpose i.e. limit your risk and therefore, almost axiomatically, your performance. They appeal to those that want to dip their toes, swim a little bit but stay close to the shore and come back i.e. not drown or delve deep. Ultimately, equity markets are not for the faint-hearted. They have been rocked by volatility, not just because of the hedge funds, but what the traders have inflicted by making it appear like a casino with leverage (i.e. not with one's own cash but borrowed sums of money).

The structured guaranteed products have tended to fall into two categories. With interest rates as low as they are, globally, whether in U.S. Dollars, Euro, Japanese Yen or Pound Sterling and with benign inflation and almost near-recession dogging every major economy, the only real performance will either come from emerging markets or from structures that take you a bit long in tenor (in the period of your investment, should the risk materialize), or give the option for the institutions to 'call' or redeem the amounts, if the bet starts to go against them. While this is done, it could be a bet against interest rates or equities or in some instances, both. Stock markets of course bet on growth in earnings in the economy and in the value creation of companies. Interest rate bets are centred around inflation; i.e. whether inflation will rear its head or whether the government's fiscal performance will improve and the like. Of course there are a whole host of other factors but in the main, these are the clear issues that attract and the structured products then get a wrapper around them, i.e. a bank guarantee, where the bets are taken either with a significant portion of your money or a small portion that is leveraged; so that the performance can be equally exaggerated. If nothing happens at the end of the period, you get your money back i.e. if it is a range accrual and the interest rates over the specified period (three, five and seven years) exceed that range, you do not get paid during that period. If it is equity markets, again, such structured products linked to indices, give you a portion of the upside, i.e. the growth in the value of the indices or nothing at all. There are variations now that are linked to hedge funds, structured or guaranteed products linked to private equity, and innovation in this field has been fast and furious.

Ultimately, what the investor is doing is indeed, giving up some potential return by opting for a much lower risk threshold. There is also an opportunity loss i.e. during the period that his money is stuck, be it one or ten years. In the event of non-performance, as intended, there is the cost of money and the potential earnings that the investor foregoes. He might regard it as a small price to pay, but this is where it all translates into risk-taking.

As they say, 'if you cannot take the heat, stay out of the kitchen'. As you stay out, a breakfast or a pantry room opens up, which does not have the kitchen nor does it have the space and the flavour and the choice that is more like a cafeteria, where you are assured of the smell of your coffee, and it does not cost as much as a fine dining room either.

Ultimately, the investor, as I have said before, tosses between greed and fear. During times of fear, guaranteed products give the right amount of comfort and the ability to go to sleep, without worrying about how the hard earned money invested is performing. During times of greed, the markets are performing brilliantly, as for instance, currently, the markets in South Asia. Then you feel cheated that you have not made the multiple-digit returns that your friend boasts of in the evening cocktail circuit.

The only worrying factor about structured products is that willy-nilly, you could end up piling up, within your portfolio, an assortment of these, that have poor liquidity i.e. you cannot get out of them in a hurry or you have managed to accumulate multiple risks that prudently, skew your profile as an investor in one direction, not necessarily intended or planned. Thus, financial planning goes out of the window, every time you start to plump for products rather than a professionally managed portfolio approach. But then, many in Dubai and some traders believe that they know everything, especially when they are winning, but blame the institutions or the financial planner for everything, when money is lost. Financial markets are hardly forgiving and will punish those that make poor decisions, either in a hurry or in an unplanned way. But some investors and traders are smart enough to use borrowed money, savvy enough to follow the markets on a daily basis and pull out even before the chips are down. That requires a time commitment and an information gathering on a daily basis, that a few except those in a full time occupation of market-watching, can afford.

The author is General Manager of Emirates Bank. However, the views expressed in this article are not necessarily shared by the Bank.

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