Structured Investment Products: The Zero
The zero’s origins lie back in the late 1990s, when fund managers in the UK investment trust sector realised that many investors were happy to receive a fixed annual return that could be rolled up and paid out at a date in the future.
This longing for a defined annual return, not paid out as income but at maturity, was eventually – by the power of financial alchemy – transformed into a zero share. The zero share was one among a bundle of share classes that these early financial engineers invented, with some shares paying out an income every year while others participated in the upside via leverage (called capital shares).
By the early part of the new millennium, however, dark clouds began to gather. This complex bit of the UK investment industry – nicknamed the split capital movement – ran into trouble as the global stock markets foundered on the rocks of dot.com mania.
The underlying assumption of this fund structure (that equity markets would always go up in value) collapsed under an equity market bubble, and suddenly a whole host of funds were unable to make those defined returns promised by the humble zero.
Flash forward a few years after this terrible event and imagine yourself in a small conference room at a large investment bank. The ‘blue-sky’ person in the corner has been charged with coming up with new fund structures that the bank salesperson can sell on.
‘Remember those zeros issued by the investment trust guys?’ he asks. Everyone nods in recognition. ‘Investors liked that idea of a steady 6 per cent a year return over, say, five or six years, rolled up at the end – didn’t they?’ Again much nodding but also furrowing of brows as they try to work out where this conversation is going.
‘Why don’t we come up with a new form of zero that isn’t in a fund or investment trust, but is a simple payout based on a defined return?’
And so was born the simple synthetic zero – the poster child of the structured products boom. Here are the basics:
You the investor give your money to the investment bank or fund manager, which issues you a £100 share or certificate.
The financial institution promises to pay you an annual compound return of 5 per cent a year for the next five years, rolled up as a final payout of £127 per unit.
A number of conditions apply to this payout, however:
The issuer uses a benchmark index, for instance the FTSE 100 index, to determine the payout. You receive £127 (5 per cent per annum, compound, rolled up over five years) as long as the FTSE 100 hasn’t fallen by more than 50 per cent. The key values for this index are the level when the zero was issued and the level when it closes (the investment matures). Your hope is that the final level is well above the barrier.
This condition is known in the trade as a barrier, and if it’s breached (the FTSE falls by more than 50 per cent from the level at the time of issue of the zero) you not only don’t get that annual return of 5 per cent but also lose more than 50 per cent of the £100 invested. The barrier is, quite obviously, a risk and not the only one.
The IOU that pays for the final maturity payout is probably an IOU issued by a large investment bank. Before Lehman Brothers went bust very few people seemed to worry about banking counterparty risk, but now everyone knows different. Banks can go bust and when they do they don’t always live up to their IOUs.
If for whatever reason you, the investor, can’t afford to wait until the five years is up and need to sell out in the middle of, say, year three, you face a penalty for cashing out early (no surprise there).
But what you probably didn’t guess was that the market value in year three is going to be determined by a range of factors that includes the prevailing level of volatility in equity markets plus the markets’ estimate of the riskiness of the bank that issued the zero. In sum, the amount of money you get back in year three depends on lots of factors.
Take a look also at two opportunity costs; that is, returns that you’ve sacrificed in order to get that defined return:
If you’d invested in the FTSE 100 through, say, a tracker fund, you may make a considerably larger amount than just 5 per cent per annum. The markets may shoot up by 50 or even 60 per cent, but you’d still only get 27 per cent with your zero.
If you’d invested in a FTSE 100 tracker comprising lots of large blue chip companies, you’d have also received a series of dividend cheques that may have been worth 2 or 3 per cent per annum. With the structured product you get none of those semi-annual payments.
In choosing a structured product and the so-called defined return, you’re forgoing potentially greater returns that you may see from other products.
You do, however, get the following:
The knowledge that you can make a nice, yearly return even if the stock markets fall by 5 or even 20 per cent per annum over those five years.
£127 per unit in five years’ time, as long as the barrier isn’t breached and the bank is still in business.
A yearly return paid not as income (which may incur income tax) but as a single capital gain in five years’ time (subject then to capital gains tax).
This incredibly simple structure has proved enormously popular and over the last ten years all manner of variants on the same theme have been brought to market, but the humble synthetic zero remains rightly popular.
Another reasonably common structure that’s similar to the zero is the standard income plan. This product looks and feels exactly like a zero in that it pays an annual return over a fixed period (usually five to six years), with the only difference being that the annual return is paid as an income year on year.
In all other respects, it’s exactly like the simple zero, with a barrier (usually at 50 per cent) based on an underlying index (usually the FTSE 100 or S&P 500).