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STRUCTURED PRODUCTSWHAT ARE THEY AND HOW THEY WORK IN PORTFOLIOS?

Stephen Ford FSI.

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Brewin Dolphin - Who?Brewin Dolphin - Who?

The largest independent private client The largest independent private client investment manager in the UKinvestment manager in the UK

£21.6 Billion assets under management£21.6 Billion assets under management

39 offices nationwide39 offices nationwide

Market independence with no in-house Market independence with no in-house funds or productsfunds or products

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What are Structured Products?What are Structured Products?

• No single Definition

• Common features includePre-defined returns

Linked to one or more underlying price or index

Payment at one or more future dates

• Essentially they are packaged derivative strategies

What could possibly go wrong?

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What are structured products?What are structured products?

Generally Consist of 3 main elements:

1. A bond repaying 90-100% on maturity – provided the issuer hasn’t gone bust!

2. An option

BUY a Call to provide upside

SELL a Put to provide downside cushion and a return to buy even more Call options

BUY a Put to provide downside return

Combine the two for a “Corridor play”

3. Costs

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What are Capital protected structured products?What are Capital protected structured products?

Strike Date Maturity

FixedInterest Bond

Call Options

Issue Costs

FixedInterest Bond

Call Options

80%

19%

100% fund provided the

issuer has not defaulted

165%of the rise in

the index

Plus Growth

Plus Interest

1%

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Where’s your bond?Where’s your bond?

56%

Senior Secured Loan

Junior Secured Loan

Senior Unsecured Loan

Senior Subordinated Loan

Junior Subordinated Loan

Equity

40%

30%

30%

Recovery Rates on Investment Grade Bonds 1971-95

Source Financial Analysts Journal Nov/Dec 1996

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Risk profile of Capital Protected ProductsRisk profile of Capital Protected Products

100% A

B

Index

C

Do you have the risk budget for the journey ?

Time

Index Level

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What are soft protected structured products?What are soft protected structured products?

Strike Date Maturity

FixedInterest Bond

Call Options

Issue Costs

FixedInterest Bond

Call Options

80%

19%

15% 100% fund from which the funds needed in

case the put option pays

out are deducted from if the

conditions are met

SCARP

265%of the rise in

the index

Plus Growth

Plus Interest

Premium from selling protection

1%

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Why pensions/life funds buy protectionWhy pensions/life funds buy protection

100% Index

Pension funds overpay for this protectionas few sellers exist

40%

Solvency Ratio

Mrs Miggins

Time

Index Level

10

Risk profile of a typical SCARPRisk profile of a typical SCARP

100% A

B

IndexIndex

C

Premium from the Put plus the interest from the bond provides for higher returns

(or costs!!)40%

D

Time

Index Level

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Structured Products – Wrappers & TaxStructured Products – Wrappers & Tax

The Structure of Structured Products

Wrapper Advantages Disadvantages

Closed ended

Offshore Cell

Company

Allowable for ISA, SIPP, SSAS

Subject to CGT

Slower to launch than other structures

Unsuitable for offshore bond

UCITS 3 Collective

Allowable for ISA, SIPP,SSAS

Subject to CGT

Suitable for offshore bond if onshore fund

More expensive to establish

Limited to 10% in any single Investment

Participation rates tend to be low due to costs & 10% rule

Medium term NotesAllowable for ISA – on issue (term 5yrs plus)

Allowable for SIPP,SSAS

Tax status not tested.

Unsuitable for offshore bond

Deposit Based

Allowable for ISA, SIPP, SSAS & Offshore Bond

Covered by the Financial Services Compensation scheme

All gains taxed as income

Generally have low participation rates

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Why invest in structured products?Why invest in structured products?

• EfficiencyEfficiency – A random portfolio of structured products has a significantly better Sharpe Ratio than a total return index.

• PrecisionPrecision Neutralise currency, interest or other risks

Reduce the risk of market timing or downside risk

Optimise asset allocation across asset classes

Access plays to new areas

• DiversificationDiversification – They diversify portfolios in ways that cash/bond/equity asset allocation cannot achieve.

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Precision Precision – Neutralise Currency– Neutralise Currency

Merrill Lynch US – launched 10th March 2004

100% Capital Protection, plus 110% participation on the S&P 500 indexfrom 1123.90 over 5 years.

160% participation on the S&P 500 index from 1123.90 over 5 years with1:1 on the downside.

Best unit trust +50.06% (Neptune US Opps)

M. Lynch US Unprotected +49.00% (2nd/70)

M.Lynch US Protected +34.00% (14th/70)

Average US Fund +31.45%

S&P 500 Index +34.86%

Source: Brewin Dolphin, Total Return offer to mid (10/03/04 – 27/05/2007)

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Precision Precision – Market Timing– Market Timing

• Morgan Stanley UK Bonus NoteMorgan Stanley UK Bonus Note Launched 23rd Jan 2008

Offers the chance to earn 15.9p per annum if the FTSE 100 index is equal or higher than its starting level (5609.30) on the first anniversary of its launch.

If the shares are not redeemed as per above then return is

100p if the FTSE 100 is higher than 3646 at maturity on 23rd January 2012.

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Precision Precision – New Asset Classes– New Asset Classes

• Close Enhanced Commodities – Launched 24th Feb 2005

100% capital protection with 200% of the change in a notionalcommodity portfolio (one-third crude oil, one-third gold and one-third

industrial metals (equally weighted between aluminium, copper and zinc) over 5 years with 12 months averaging.

Close Enhanced Commodities +269.30%

Goldman Sachs Commodity Index +101.00%

Change in Commodity basket +108.61%

Implied Final Entitlement +317.00%

Source Close Fund management offer to mid (24/02/05-06/03/08) & Datastream

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Precision Precision – New Asset Classes & Ideas– New Asset Classes & Ideas

• Barclays Japanese REIT Note – Launched 20th Jan 2006

100% capital protection with 190% of the change in the TSE REIT index from 1,641.58 over 5 years with 12 months averaging.

• ML High Income Note

1.45%pa over 6 month Libor with full return of capital unless FTSE 100 trades below 3,667

• Morgan Stanley Leveraged Bear Note

300% of the fall in the FTSE 100 over 2 years from 6,204, capital protected unless index rises above 8,065 with max payout of 167%

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Diversification Diversification – Less Correlated Returns– Less Correlated Returns

Merrill Lynch Defined Income & Growth Launched 14Merrill Lynch Defined Income & Growth Launched 14 thth Dec 2000 Dec 2000

The structure offered a maximum return of 10.37% pa, if a basket 30 equally weighted large cap global equities remained above 80% of their initial level. The maximum return would erode if one or more of the stocks fell by more than 20% at the end of the 3 year term.

Over the investment period 27 of the 30 stocks fell. The actual returns were:

Merrill Lynch Defined ReturnsMerrill Lynch Defined Returns +4.5%. +4.5%.

The large cap global share portfolio -32%

FTSE 100 -30.6

S&P 500 -19.9%

Source: Merrill Lynch

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Diversification Diversification – Less Correlated Returns– Less Correlated Returns

Merrill Lynch Capital Acc VI Launched 6th February 2008 – CASH COLLATERISED

Return increases by 11p each year and product will autocall if FTSE 100index finishes equal to or above the following levels. Launched at 100p

6th Feb 2009 5287.86 111p

6th Feb 2010 4700.32 122p

6th Feb 2011 4112.78 133p

6th Feb 2012 3252.24 144p

Capital Protected unless FTSE 100 index trades below 2,800

All Taxed As CGT

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ML Capital Accumulation VI - ML Capital Accumulation VI - Hedge Fund Beater? Hedge Fund Beater?

0

1,000

2,000

2,500

3,000

3,500

4,000

4,500

5,000

5,500

6,000

Yr1 Yr2 Yr3 Yr4

11p

22p

33p

44p

Strike/Starting Level

50% Soft Protection

FTSE 100 Index

Potential Returns

CAGR 11%pa – 9.50%pa

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Dynamic ManagementDynamic Management

Falling Participation

Interest rate Discount – Pull to redemption

Capital At Risk

Falling Participation

Index Client Capital Protected Level

C

B

A

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Structured Products – A word on Risk…..Structured Products – A word on Risk…..

• THIS STRUCTURE IS NOT PRINCIPAL PROTECTED AND INVOLVES SUBSTANTIAL RISKS SUCH AS LOSS OF CAPITAL.

  • Credit Risk: This investment has an element of capital protection which is dependent on the creditworthiness

of the issuer – XXX. In the event of default, investors would face a large capital loss. • Market Risk: The return on the investment is linked to the performance of the XX index, which could be zero

or negative.  • Liquidity Risk: The shares will not be traded on an organized exchange. Although, the issuer will make a

secondary market in the shares on a best efforts basis, the liquidity of the shares may be limited. The liquidity of the shares reflects the liquidity of the securities that underlie the investment.

  • Exit Risk: The secondary market price of the Security will depend on many factors, including the value and

volatility of the underlying equity, interest rates, the dividend rate on the stocks that compose the indices, time remaining to maturity and the creditworthiness of the Issuer. Prior to maturity, the holder may receive an amount which may be less than the amount the holder would have received on maturity of the investment.

 •  Interest Risk: Unlike many ordinary shares, this investment does not pay dividends. The return of the

investment could be nil or negative and therefore will not compensate you for the effects of inflation and other factors relating to the value of money over time.

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Portfolio EfficiencyPortfolio Efficiency

Source Merrill Lynch

16.5%

17.0%

17.5%

18.0%

18.5%

19.0%

19.5%

9.5% 10.0% 10.5% 11.0%

Risk

Retu

rn (an

nu

alized

)

MSCI World

MSCI World ex-Japan + 9D (225% of Topix no prot)

MSCI World ex-Japan + 9C (140% of Topix 100% prot)

MSCI World ex-Japan + 13C (185% of Topix 100% prot)

+0.3%

+1.0%

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Structured Products - SummaryStructured Products - Summary

• A new market - There will be problems!!

• Clients must understand the product and its changing risk profile

• Multi-index products tend to lag NAV more than single index

• Need dynamic management

• “long only” managers and financial advisers can bet on the downside

• Back your investment view NEVER the product

• Structured Products is a broad term – CDO/CLO etc

Experience tends to suggest that they add value at portfolio level

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Disclaimer Disclaimer

“This presentation is intended for financial professionals only and should NOT be distributed to, or relied upon by, those who could be classed as retail clients.

The information contained in this presentation has been taken from public sources and is believed to be reliable and accurate but, which without further investigations, cannot be warranted as to accuracy or completeness. The opinions expressed in this document are not necessarily the views held through Brewin Dolphin Ltd. No Director, representative or employee of Brewin Dolphin Ltd accepts liability for any direct or consequential loss arising from the use of this document or its contents “

Brewin Dolphin Ltd. A member of the London Stock Exchange, authorised and regulated by the Financial Services Authority.