Try saying “securitized derivatives” in a conversation with an Italian investor, and you are unlikely to get their attention. Unless you add two sure-fire words afterward: “capital protected.” Certificates (or certificates) are also: capital protection instruments, but not only that. It is a vast universe in which end investors need a solid financial background to find their way around. It is common to come across promotional communications pushed by issuers on various channels or unappealing certificate rejections: can they be useful for advisors to build their clients’ portfolios? We Wealth asked four independent observers: Rocco Probo (Consultique Scf), Matteo Cadei, Andrea Bosio (Aegis Scf), and Edoardo Mancinelli Scotti (HCinque Financial Advisor).
The fact of the matter is that the certificates market in Italy shows a growing trend and, in 2022 alone, generated issues of 16.2 billion euros: the highest value ever after that recorded in 2019 (17 1 billion). According to data from the Italian Certificate Association (Acepi), 60 percent of certificates issued last year were capital-protected forms, and another 23 percent were conditionally capital-protected.
Certificates, a brief sketch
The primary characteristics of the certificate are that its return is derived from the performance of one or more underlying (indices, stocks, or other) under conditions that are specified in the contract from time to time. The variability of these conditions can often confuse, partly because each issuer uses different labels to promote its product. In addition to these aspects, it should be considered that having a certificate in the portfolio does not amount to direct ownership of the underlying assets but is a relationship between the investor and the company that issued the product-thus; if the issuer were to default, the certificate would be treated as a bond, with the possible loss of the investment. Even for “capital-protected” certificates, protection is contingent on the issuer’s financial strength.
Last, but far from minor, is the tax treatment of certificates whose returns are considered “miscellaneous income,”: making them helpful in offsetting capital losses recorded on mutual funds and ETFs. As we shall see, some advisors think this feature to be decisive in choosing to include certificates in the portfolio.
How to profitably exploit certificates
All three advisors reached by We Wealth agree on the usefulness of certificates with the most straightforward construction. “Among the main structures are benchmark certificates,” said Probo, “these are instruments that, like Etfs replicate an index, albeit with poorer levels of liquidity and with the issuer risk mentioned above.” Why prefer a certificate with the same features as an Etf, albeit with higher costs and lower liquidity? This is where tax considerations come into play.
In the Italian tax system, returns from some types of investments are considered capital income (individual stocks, bonds), others miscellaneous income (funds, Etf, dividends and coupons). Capital losses can only be offset within each category, with the unfortunate drawback of being unable to “take advantage of them all,” thus paying more tax. “Investments in certificates offer an advantage from a tax point of view since the coupon and capital returns generated by investing in these instruments are considered as miscellaneous income,” said Cadei, “meaning that there is the possibility, from a tax point of view and for four years, to offset any capital losses,” resulting from the sale of mutual fund shares or Etf-the most popular products in the portfolios built by professionals.
Mancinelli Scotti recounted that the losses incurred in the markets in 2022 made the certificates particularly attractive at this market stage because the gains produced by the certificates over the next four years can be offset for tax purposes against the capital losses that hit the portfolio in 2022. (This benefit may also interest foreigners who are tax residents in Italy.) Beware, however, “there are different categories of certificates, and not all of them can be used if the purpose is to offset capital losses,” Cadei pointed out, “it follows that the professional support of an independent financial advisor is essential to help the client/investor understand whether or not the certificates (especially which ones) can be included in the overall financial planning.”
In addition to “benchmark” certificates, another category to consider “are digital certificates: they can be compared to corporate bonds whose coupon, being random, could generate a higher return than the yields present on the market,” Probo said, “At maturity, as in the case of bonds, they repay the nominal principal, thus limiting potential losses.”
Mancinelli Scotti considers certificates offering coupons of this valuable type because they support “the goal of having a little less volatility with coupon yields that are tax-compensable and tend to be higher than bond yields.”
Finally, conditionally capital-protected certificates can offer positive performance even during slight declines in financial markets. They can be considered with careful analysis of the underlying, especially when the worst of the “bear” market can be considered disposed of.
“In general, Consultique tends to prefer simple structures without additional conditionalities such as ‘worst of,’ ‘best of,’ and other elements that complicate the assessment of expected returns and may increase the complexity of the instruments,” Probo said. In addition to the problem of complexity, “the most trivial mistake one can make,” Mancinelli Scotti concluded, is to “buy multiple certificates with similar underlying,” with the risk that they may go bad simultaneously: better to diversify not only among different certificates but also the underlying and buy them from different issuers to minimize the risk of default.
Certificates, which ones to use most frequently (and which ones to avoid)
“The world of certificates is very vast, and several intermediaries operate, characteristics that produce in the eyes of the investor a justified confusion,” said Rocco Probo of Consultique, “the types of products are many, with obvious differences in terms of operation, and the trade names assigned to similar products by different intermediaries are different adding to the difficulty in comparison and evaluation.”
“If we wanted to reduce everything to the bare minimum, we could still distinguish certificates into four broad categories: namely, capital-protected products, conditionally capital-protected products, noncapital protected products, and leveraged products.”
All four respondents agree that, among these different categories, many can prove helpful in building an investment portfolio, as we will see in more detail. The type avoided in most cases, however, is leveraged certificates-which multiply the risks and potential volatility of the instrument. “They are difficult to bring back into the risk profiles tolerated by clients, and should the investment go wrong, it would be difficult to explain why a particular certificate went to zero,” said Mancinelli Scotti of HCinque.
Then there are also conditionally capital-protected certificates on the market that offer great coupons, “but which have risky underlying” and could fall below thresholds within which capital is protected (so-called barriers). That of certificates is a matter in which do-it-yourself by the end investor is particularly risky because there are so many variables to consider, Mancinelli Scotti said. These considerations become a priority when in the gray area of a product that offers capital protection but only in some cases. How to figure out how strong the protection provided is, and how much more or less likely the protection is to “blow away”?
“Conditionally protected capital certificates allow you to benefit from the rise in the underlying asset and at the same time can protect your invested capital. This is, of course, provided that the value of the underlying does not reach a certain barrier level,” explained Matteo Cadei of Lixi Invest, “Should the value of the underlying reach the barrier level, the protection of the invested capital is lost, and the financial instrument would behave like a certificate without capital protection.”
“For example, a 60 percent barrier means that in the event of a drop in the underlying of 40 percent or more, the investor loses the capital guarantee,” Cade added, “consequently among the main factors to be analyzed when evaluating the inclusion in the portfolio are the type of barrier (monitored continuously or discretely, i.e., at maturity), the width of the barrier itself, and the volatility of the underlying.”
In the basket of underlying, which determines the possible breach of the barrier, it is not uncommon to see ‘suspect’ securities, whose valuations are much higher than those of the other securities in the basket and which could increase the chances of a sharp drop. Such is the case with certificates that, in 2021/22, had included one or more high-risk technology stocks correction against a backdrop of expected rising rates. Mancinelli Scotti said these are far from random constructions that are more likely to allow the issuer to take home a profit (to the detriment of the investor). These warnings indicate that prudence and professionalism are imperative when selecting certificates, mainly when the underlying is individual securities.
