Structured products look much more risky under Priips, Cube

The new European Union Packaged Retail and Insurance-based Investment Products (Priips) regulatory technical standards (RTS) which define how the risk and return of structured products have to be calculated from January 2017 "suggests that many products that previously may have been considered low risk will have a much higher volatility under the new regime", according to an analysis paper published by Cube Investing.

The effect of these new regulations may have a dramatic effect on the type of structured products offered to investors as many products that were considered suitable and appropriate for defensive and cautious investors until now "may be deemed to be too risky" under the Priips framework, according to David Stuff (pictured), managing director and founder of Cube Investing.

The UK firm believes that some of the choices made by the regulator will "minimise the benefits" that structured products offer in particular the way that volatility is calculated and the restriction around the observation window used to collect data for the stress test which will generate some "strange results where short term performance becomes extrapolated to be a long term trend". In addition, Cube believes that the risk buckets are very wide, and probably less granular than most attitude to risk scales (Risk bucket 3 includes products where the volatility is between 5% and 12%. Bucket 4 goes from 12% to 20% and bucket 5 starts at 20% and extends to 30%. This could match to the old low / medium / high classification, but they seem a bit clunky in today's environment if there is no decimal point.)

"We're finding it very difficult to work out the return projections of the final draft as it is not possible to make return projections for a six-year auto-call and provide the one, three and six years projection requirements for products that might expire after one year," said Stuff. "The risk calculations are restricted to the last five years which means that simple passage of time and the difference in the inputs could make structured products look much more risky."

According to Stuff, as the inputs window changes the riskiness of the products will also change as the new index returns are calculated using the distribution of daily returns from the last five years.

"For funds with the bootstrap you take the historic returns to calculate the risk but for structured products you're taking the bootstrap results but then you are shifting it down so the median results in the bootstrap are aligned with the risk/credit rates," said Stuff. "Basically you are shifting down the underlying results assumptions for structured products which is broadly a risk mutual underlying assumption. This is almost like coming up with a fair value calculation for structured products which is very different and a significant shift from was originally expected."

Under the new rules, the volatility of returns on a six-year FTSE Autocall with a 60% downside barrier paying 5.8% pa. is 14.7% and falls under risk bucket 4 which includes products with volatility of 12% to 20% so will include developed market equity funds, according to Stuff. "It seems strange to us to put a product that could offer a 35% return even if the underlying market has fallen by 40% in the same category as a FTSE tracker," said Stuff. "This means that the risks of products with soft protection increases and the soft protection basically disappears in the risk calculation."

On the requirement to generate the Key Information Document (Kid), which falls on the product manufacturer - although it is not always clear who is the manufacturer, Cube believes that investment managers and advisers that specify their own product terms and hedge the product through one or more issuers "are clearly assuming product manufacturing responsibility".

In Europe, this requirement seems to be more obvious because the banks issuing the products (the manufacturers) will create the Kid. In the UK, however, is slightly less clear because the FCA has imposed additional requirements on product manufacturers such as defining the target market, and match your offering and the distribution to that target market. As a result, it is not clear if those dealing with advisers and product manufacturers (Meteor, Walker Crips) will have to produce Kids on plans that are no longer available, according to Stuff.

"It is possible that issuer and investment manager are both responsible, we have already heard lawyers talk about co-manufacturing," said Stuff. "We think that issuers and wealth managers will both look to each other to comply with this regulation and assume that the other will pick up the tab. Most issuers are simply not set up to do the stress testing as prescribed by the RTS."

As a result of the new provisions, Cube Investing expects that the risk-return calculations requirements "will encourage the use of quantitative analysis to support the use of structured products in client portfolios because structured products can be shown to expand the efficient frontier", while the risk rating will help "more managers and advisers to consider using structured products".

Cube also anticipates an increased demand from discretionary managers for companies that can assume responsibility for product manufacturing that sit between issuers and investment managers. "Companies like Cube can take on the FCA manufacturing requirements, and offer Kids on the products we manufacture," said Stuff. "We are working towards being able to offer the full suite of risk and return numbers required for the new Kids. Even with what we know now, it is clear that product issuers, manufacturers and distributors all need to be aware of the impact of these regulations, and should start to plan how they will react."