Structured Products as Investment Tools

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Intro: 00:01 Nalu FM Finance Podcast. Insight into the financial markets.

Tim Mortimer: 00:11 Really any analysis that you have of a portfolio should be very much geared to chances of loss as well as what's on the upside. And I think their structured products actually have a built-in advantage.

Advertisement: 00:24 This podcast is powered by Vestr, the engine behind Active Management. Vestr is a Switzerland-based fintech startup that provides software for issuers of actively managed certificates to automate their value chain fully. Visit Vesta, V-E-S-T-R.com to schedule a meeting with an expert and to learn more about Vestr.

Stefan Wagner: 00:46 Welcome to today's episode of the Nalu FM Finance Podcast on how to invest in structured products. I'm thrilled to have Tim Mortimer from FVC with us. Tim is the managing director and founder of FVC, a firm specializing in structured products and derivatives. Tim and I met over 20 years ago in the city of London, and our path have continued to cross ever since. I've always admired Tim's exceptional ability to demystify complex financial concepts.

Tim Mortimer: 01:17 Thank you, Stefan. Great to be talking to you and looking forward to doing this interview together.

Stefan Wagner: 01:24 Thank you. Tim, you began your career in derivatives immediately after graduating from university and have consistently focused on the use of derivatives and structured products as investment tools throughout your professional journey. So my first question to you is, why should investors consider investing in structured products?

Tim Mortimer: 01:45 Well, that's a great question to start with. And of course, it's a very important one. And there's no single right answer, as you might expect, just like there's no single answer as to how should I invest in general. The typical investor that would want to look at structured products would be one who is quite happy with the idea of equity investing in general, and also places a value on income generation and capital protection. 

And what structured products do is they combine elements of those and provide a different solution, as we'll talk about later. So really the main reason to start considering it is for an investor that wants to get some market growth or participation or income but is not happy with just taking direct equity risk and is also not happy with interest rates alone, particularly of course when they've been very low.

Stefan Wagner: 02:39 Now that you convinced me as a potential investor, how do I start investing in structured products? Do I take already existing products that are listed? Do I go for subscription-based products where there's a subscription period of months where I can subscribe to them? Or do I want my own tailored one? What do I take into consideration when I go down that road?

Tim Mortimer: 03:02 So, it very much depends on, first of all, the country and market that you're talking about. So, obviously, you've got strong connections with Germany, Switzerland, other places. We're based in the UK. They all have quite different regulatory and investment setups. even though the structured products themselves were actually fairly similar across different markets. So, in the UK, for example, most products are delivered through advice sales, so financial advisors with the investors. And there are always a set of open products that an investor can consider. 

In Switzerland and Germany, there's a large number of certificates. We're talking literally hundreds of thousands. It's mostly self-directed by investors, so the advised portion is much smaller, more or less non-existent. So that's one big difference to see. But if you're an investor with a, you know, what you might call a reasonable investment portfolio size and would be looking to invest 10 or 20,000 euros at a time, nothing really more than that, then those two routes would be the appropriate one depending what market you're in. If you're a high-net-worth investor and might be looking at perhaps a million euros over a year, for example, then you would have other options and then you're going into the more bespoke range or a direct relationship with a private bank.

Stefan Wagner: 04:26 Now, one of the advantages of structured products is that the payout is deterministic, so it's a defined outcome. You know based on the formula what you get at expiry. I think that's a trickier one has to say. So, when buying a structured product, you know exactly what you will get at expiry based on the terms. Nevertheless, during its life, the structured product often behaves in a way that is hard to understand, particularly for first-time investors. Why is that, and should you be worried about it?

Tim Mortimer: 04:57 Again, that's a very interesting question and also a very important one. So, you're right. Structured products are often described as defined returned investments. And I like that description, actually. I think it's a very good one. So, essentially, any given structured product is a combination of some kind of payoff formula or description and an underlying asset. We have various fundamental product constructions, such as protected equity-linked products, high-income, what are called reverse convertible, or auto-call products. So, they all have different payoff considerations, and they generally fall into one of two categories, either some kind of growth with risk control, or some kind of enhanced income and yield strategy, so getting more than the risk-free rate at manageable risk. 

So, you put those two together, you have a payoff and an underline. The underline could be a mainstream index, Eurostox, SMI, S&P, FTSE, Nikai, whatever. Return of the product will end up being how the underlying has performed and how the payoff definition of the product applies that. So you look first of all at what the underlying has done, look at the terms of your contract, and then that translates to product performance. It's those two things that go together. There are no other external factors to worry about. Crucially, there's no fund manager that is doing anything on a discretionary basis. So you're not subject to a fund manager having poor performance, even when equity markets were strong. 

So that's the good news, really. But in terms of understanding how a product will behave during its lifetime, that's where you do have to have a strong education process for an investor to truly get a handle on it. And there's various factors that are important there. For example, a product may be fully protected past, perhaps, a five-year maturity point. But yet, in the early first or second year of the product, you might find that it trades significantly below its initial capital level. 

And that sometimes is surprising to investors. They get told that a product is fully capital protected. The market perhaps goes sideways or slightly down. and then suddenly their statement is showing a value of perhaps 90% and that's a little worrying. But the crucial thing to understand is that protection and all other features are generally defined at maturity and if you hold the investment, that will come back.

Stefan Wagner: 07:38 Are there sort of techniques and tools that can help investors to better understand and predict such the behavior of structured products?

Tim Mortimer: 07:48 Yes, so there certainly are. There are ways to look at structured products. The first thing that I would say to that is, given that these products are aimed at retail investors and would typically only form five or ten percent of their portfolio. There are some advisors and investors that are extremely evangelical about structured products and might try and put higher proportion than that but many regulators make that very difficult to happen and so five or ten percent is a kind of accepted proportion so tactical proportion in many markets. So given that, you really want a framework where analyzed and structured products will sit within the rest of your portfolio. So you've got 90% being held in maybe equities, bonds or cash. In terms of analyzing their performance, the structured products are a little bit different to what I call conventional assets. 

So equities, cash, open-ended, simple investments. What structured products provide on top is much more granular and tactical product outcomes, as we've already started to discuss. So there are different ways to analyze it. So our firm specializes in various services, which helps that. So we provide independent valuations, for example, to firms that are selling and dealing in structured products. So investor will have not only the price from an issuer, but also be able to source an independent valuation from a third party, which is quite important. And there's also special techniques. Again, we're involved in this business. for what's sometimes called stress testing or scenario testing, where you can look to see how a product might behave before you purchase it.

Stefan Wagner: 09:41 I find that very useful historically when we were selling such products. If the investor can go through certain scenarios that maybe even creates himself and sees what the payout based on that scenario will be, they suddenly get a much better understanding than reading a 50-page pricing supplement.

Tim Mortimer: 10:00 Yes, and that also goes hand-in-hand with it. So the defined return concept is great. It tells you, if you have the discipline to say, this is the underlying performance, this is my product, this is what I should expect. It doesn't really give you any handle on the likelihood or magnitude of different scenarios, which is what stress testing is all about. Then the final piece that I should say, which some weirder firm are working on, and others in the market are as well, perhaps the Holy Grail is deeper tools to allow structured products to be properly analyzed within a portfolio alongside conventional. So that's something which I think is a bit underserved at the moment and that would be an extremely useful tool.

Stefan Wagner: 10:43 Now that you convinced me, that a structured product is a good investment and I want to invest in it, but how do I integrate this product in my overall portfolio? Is it by risk category, skew, kurtosis, investor utility function? I don't know what to use or do I always keep it in this alternative satellite and it's allowed to live there by itself?

Tim Mortimer: 11:09 So you're right, people have tended to just throw structured products into some kind of alternative category, generally because that's only existed in portfolio systems. But that's a little bit of a cop out because that's really supposed to be for things like perhaps real estate, illiquid assets, art even, hedge funds, they don't really belong in there. They are defined risk equity linked investments or perhaps other asset classes. There's also, let's not forget, you can have fixed income or commodities FX, exactly. So, what the market really needs, I guess, is a plug and play portfolio analysis solution on top of the way that people think about their conventional portfolios right now.

Stefan Wagner: 11:56 Obviously, you know, many investors will look at this and say, okay, great. I bought a structure products, but how do I know, measure or compare its success? You know, when you measure investment success, the several key numbers that came calculated in a return investment, total return, annualized return. or then when it comes to risk like, you know, Sharpe ratio, Sartinio ratio, all these can be calculated to reflect the risk taken to achieve these returns. But all these ratios were originally developed for linear investments like a stock, you know, it goes up by 1%, you make 1%, if it goes down 1%, you lose 1%. But as structured products are often asymmetric, I don't think they do really work. Is there a better way to reflect the risk versus return? Or is there different ways even per structure product depending on its payout?

Tim Mortimer: 12:48 Yes, that's again an interesting question from you Stefan. So the most structured products is all about key levels of either return or risk avoidance. So it's targeted income level. It's trying to avoid capital loss, either any capital loss or simply significant capital loss. So really, any analysis that you have of a portfolio should be very much geared to chances of loss as well as what's on the upside. And I think their structured products actually have a built-in advantage.

Stefan Wagner: 13:26 But what is the right thing to use for structured products keeping in mind that it's often a combination of equity and fixed income exposure and they have the non-linear structure? Should the equity market also be applied as a benchmark for structured products or is there a better one?

Tim Mortimer: 13:44 So I certainly wouldn't say that equity, direct equity as a benchmark is the right way to think of it. If anything, people tend to view performance versus cash. Regulators have sometimes gone down that road, but that's not really appropriate for capital risk structure products because it can be very easy to try and beat cash when they perform well. Of course, when they lose money, you've then got a difficult comparison because cash will not do that. 

So I would say logically, economically, the best benchmark would be something like a 50-50 portfolio of equity in cash, or maybe 40 equity, 40 bonds, 20 cash, something like that. In some of our systems, we show that kind of analysis. But I have to say, it's not really being universally adopted by people. Again, that's something that I think the market still needs to think about and develop.

Stefan Wagner: 14:41 I mean, you mentioned that you use that in your systems as a benchmark. I mean, could you share how historically structured products on average, not an individual one, but have done versus such a basket of 40, 40, 20?

Tim Mortimer: 14:56 Right. So from the data that we compiled for both the UK and the US market, they performed very well over a long period against both of those benchmarks and would expect to comfortably beat them in my experience and opinion.

Stefan Wagner: 15:12 Now, I mean, I also worked for a long time in the structure products world and still do. And often I've seen there's sort of a little bit of a, I would call it a suboptimal selection process. You know, either people sold for the highest coupon for a yield product, you know, and pick basically a stock that has the highest volatility or if it's multiple stocks, you know, the lowest correlation. And also, or the other side, the highest participation for capital product to product. And I find that rather suboptimal, and I think it should be done different, but I would love to hear what you think about it. How should it be done and what is to be considered?

Tim Mortimer: 15:53 Right, okay. Yeah, so I've seen solutions in the area that you're talking about. So this is typically put out by investment or private banks or distributors. If you've got an investor that might theoretically be happy to consider from several stocks or indices, we've built this mathematical model that can go away, crunch the numbers on all these, say, 100 underlines, we'll look at the volatility, the dividend yield, and the correlation, and come up with the one that achieves the highest yield. It gives you 9.05, and the next five in at 9.04. I do not like that approach at all. I think that's extremely dangerous and misleading practice. 

One of the drawbacks of, I guess, the defined return approach is that you can have these headline terms, yield, or even participation. And while that is an important number, and in terms of describing a product, it's the most sensible number, you shouldn't just blindly go after that at the expense of everything else. So if you have a clever optimizer that says, okay, today, these particular 20 stocks will give you the best yield, done as a basket or a worst of whatever's being considered. You know, that says nothing about the prospect of those stocks, the likelihood they have of avoiding capital loss or enough to avoid the products being in trouble. 

It also says nothing about the recognizability and suitability for investors, its diversification. I think you should be starting with the underlying assets that you're comfortable with first. If you've never heard of an underlying or not comfortable in holding it directly, you'll be unlikely to want to have it in a structured product. So choose your asset allocation, your risk level, the high-level questions first, and then you could start to, at the margins, perhaps substitute one or two stocks to make the yield a bit higher, perhaps vary the maturity, perhaps vary the risk level. But do it front to back, not back to front.

Stefan Wagner: 18:10 I couldn't agree more. I wish that is the way that they would do it, but unfortunately often it's not. Now, there's a lot of myths about structure products. And if it's okay with you, I would like to throw you a few myths and maybe you can dispel them. So the first one is sort of, I feel like often regulators particularly sort of mix up complexity versus complicated and I don't think complex is not equal to complicated. What are structured products in your opinion, complex or complicated?

‍Tim Mortimer: 18:51 They shouldn't really be either to be honest. So it's not the same as just investing in an S&P ETF or investing in a CD or deposit. They do have more moving parts, which is why education is important. But for an investor to consider a structured product they're comfortable with and use that same construction over a number of years, that's not really complexity. It's just something that needs to be understood before you start.

‍Stefan Wagner: 19:23 Now, another criticism sometimes you hear of structured products and slash derivatives is that they are a zero-sum game.

Tim Mortimer: 19:32 Yeah, I've heard that one as well. So the investor is the one that's looking to make the gain. The bank is simply there to provide the assets. There's no competition or tension in there.

Stefan Wagner: 19:43 Yeah, I mean, it would be, I think, surprising to a lot of people to find out actually that there are scenarios where the investor makes money and the bank can make money in that process, but also vice versa, the investor can lose money. And at the same time, the investment bank might even have lost hedging in the process of money. It is not zero-sum game that the money that the investment bank makes, the investor will lose or vice versa. Another thing is that structural products are apparently only for wealthy investors, and I never quite understood this, why regulators thought that only wealthy people are clever enough, or that wealth is a sign of higher intelligence to understand that they can invest in structural products. But I don't know what you think.

Tim Mortimer: 20:30 No, again, I don't really agree with that because if you were an extremely wealthy investor, you would probably have very strong views and capabilities that are not open to those small portfolios. But for someone with the typical 10 or 20,000 euros, which to them would be a decent sum to invest, Then, structured products is the tried and tested way to actually achieve a defined return that sits between cash and equity. So, I would actually argue that they are most important for normal size investors, not wealthy investors.

Stefan Wagner: 21:08 The other myth often is that structured products are only useful in bull markets.

Tim Mortimer: 21:13 No, I wouldn't agree with that. In fact, their sweet spot is slightly volatile markets. those that are actually not really going very far. So the AutoCall product, which is very popular everywhere, actually its sweet spot is when markets are not really doing very much and you wouldn't get very much for direct investments nor from cash, but AutoCalls can generate from the way they're put together and the rationale they have a decent return.

Stefan Wagner: 21:43 The other myth is sort of what is actually the fair value of a structured product and Will an investor ever pay a fair price or is it an unfair price?

‍Tim Mortimer: 21:56 So if you consider other types of investments, so funds of different kinds, they all have few structures built in. With the way that regulation is today, there's a high degree of cost disclosure. across the board. And there's also a lot of competition. So between those mechanisms, the investor is able to see what product is costing them. In the UK, actually, last summer, so it's coming up for a year old, there was a big piece of regulation called consumer duty, which was putting a much higher emphasis on firms doing the right thing by their investors, i.e. the consumers, in terms of cost disclosure and also appropriateness of cost level. And so as part of our work for our UK clients, we analyzed, I think it's nearly 1,000 products that have been in the market since that started, and we did a very detailed analysis of costs and also actually ex-post returns. 

So we said, compared to typical unit trusts and funds, how does the cost level of structured products stack up? And we were using our own analysis and also the bank-provided PRIPS data, which is a sort of legally binding document. And we found that structured products were no more expensive than mutual funds. And then when we did a analysis of the returns, we divide the structure products from, into capital at risk and capital protected, which is always the big dividing line. And we compare the capital protected ones to deposits and very low risk funds. And we compare the capital at risk ones to a combination of deposits and equity, going back to what we said earlier about benchmarks. 

And we were able to show that, again, for hundreds of products that have matured in the last couple of years, the performance of structured products has been higher than the respective peer group, whether you consider protected or at-risk products. So those are two very compelling stories. We believe structured products serve the investor on the way in with costs and on the way out with returns. So that's a pretty strong story.

Stefan Wagner: 24:18 Now a question for you that I always like to ask everybody at the end of the interview. What is your current favorite music or what is on your current Spotify playlist or if your old school CD or vinyl?

Tim Mortimer: 24:34 So I've actually got a few artists I like to listen to. I like to sort of diversify, shall we say. The Weekends and Dua Lipa, both are great artists in my opinion that are current. But if I'm feeling like an old school track, I usually dip into Blur now and again.

Stefan Wagner: 24:51 Excellent. Thank you. Last question for you. Your company definitely helps people when it comes to structured products. You do a lot of interesting things. If somebody would like to get hold of you and talk to you more about it, how can they reach you?

Tim Mortimer: 25:06 go on our website futurevc.co.uk and drop us an email from the contact form or myself on LinkedIn. I always like to talk to new people.

Stefan Wagner: 25:17 Excellent. Thank you very much, Tim, for taking the time.

‍Tim Mortimer: 25:21 Thank you, Stefan, for inviting me. Great to speak to you.

Outro: 25:25 Nalu FM finance podcast. Insights into the financial markets.

Advertisement: 25:38 This podcast is powered by Vestr, the engine behind Active Management. Vestr is a Switzerland-based fintech startup that provides software for issuers of actively managed certificates to automate their value chain fully. Visit Vester, V-E-S-T-R dot com to schedule a meeting with an expert and to learn more about Vestr.

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