Passive investment with a twist?

When debating the issue internally, there was a general consensus that it is difficult to assess the future performance of active fund managers. Therefore, although the top performing funds seem to offer beneficial performance in return for the charges applied, the selection of a particular fund often comes down to past performance, which, as we are constantly reminded, is not a reliable guide to future performance.

We agreed that investing in passive, or tracker, funds offers exposure to the selected market, without having to choose which fund manager might outperform, so we considered the following passive investment options.

Exchange Traded Funds (ETFs), such as iShares offer a simple way to gain access to the target market in a very cost effective manner. However, although the costs are relatively low they still, by their very nature, cause a fund to underperform, however modestly, the index being tracked, over the long-term.

Five-year performance of iShares funds



Source: Financial Express Analytics

Structured products – investment products which utilise derivatives to meet specific needs that cannot be met from standard financial instruments - offer passive performance, but can be designed to give better upside performance with the opportunity to limit downside risk. These products can be created in a number of ways, but the three main types offer either:

• Capital protection, typically of between 90 and 100 per cent. of the investment, combined with gearing on the upside.
• Partial capital protection with gearing on the upside, but the protection is lost once a barrier, usually 50 per cent of the initial index level, is broken on the downside.
• Unprotected structures with full downside risk from the initial index level, but with significant gearing on the upside.

The unprotected option is the nearest comparison to iShares, as they both carry full downside risk, but unlike iShares the structure typically offers significant upside gearing, which can produce two or more times the growth of an index, after taking account of costs.

This means that an appropriate structured product can produce significantly better returns in a rising market than an Exchange Traded Fund, for the same level of market risk. However, a structured product is guaranteed by the issuing institution, so an investor has to accept some counterparty risk.

Needless to say debates such as this rarely produce a unanimous conclusion, but it is clear that there should be a place for structured products, within a balanced portfolio. To return to our initial theme, these products, structured correctly, can achieve our objective of exposure to emerging markets.

Wayne Ellis is sales director at Merchant Securities. The view expressed here is his own.