Structured products under the microscope
Where can you go to get a decent return? If you lock your money in a top savings account for a year, you’ll get 2% if you’re lucky. With these paltry rates on offer, it’s easy to understand why savers and investors would want to look elsewhere to see what’s available.
Structured products can potentially do much better. The average return on maturing structured products sold by Ifas between February 2008 and December 2015 was 3.76% annualised, with the top quarter of all products delivering average gains of 7.24% a year.
However, critics call them complex instruments. They cite products sold by Lehman Brothers that failed to deliver when the bank collapsed, triggering turmoil in the financial markets, or the mis-selling scandals that surrounded poor-value products that used to be pushed hard by high street lenders.
So where does the truth lie? Here’s a look at how they work, the risks, and the potential rewards on offer.
What are structured products?
Structured products are essentially agreements between you and a bank (‘the counterparty’), that it will pay you a certain amount of money if some conditions are met, perhaps that the FTSE 100 index, or a selection of shares in a few companies, increase in a given period of time.
There are two main types: deposit based and capital at risk.
Deposit based accounts are similar to savings accounts. The amount you invest won’t fall, so you’ll get back what you put in. As with savings, your first £75,000 is protected under the Financial Services Compensation Scheme (FSCS).
However, the interest or growth you’ll receive depends on certain conditions being met – for example, if the FTSE 100 holds its value over an agreed timeframe. The risk is you’ll get no interest if it doesn’t.
With capital at risk products, you could lose some or all of your investment, but potential returns are higher. A capital at risk product that’s linked to the FTSE 100 might pay 10% interest if the index is the same or higher in one year’s time.
But it might also include a clause that if, after 12 months, the FTSE was at least 40% lower, the loss would be crystallised, with your investment’s value falling by the same percentage as the index.
These capital at risk products are investments, not savings, but there’s still a degree of protection from the FSCS in the event that the issuing bank can’t pay you at maturity, up to £50,000. This doesn’t cover losses from poor market performance, or counter-party risk (which is the potential for the company on the other side of your contract goes bust, or can't meet its obligations to pay) though.
Of the Ifa-distributed structured products analysed by CompareStructuredProducts.com, while average returns were high, 108 of the 484 maturing products returned only the original capital, so investors missed out on any interest or dividends their money would have earned elsewhere. While none of these investments lost money, that’s not to say they couldn’t in future.
How complicated are they?
Structured products are sometimes criticised for their complexity, as they’re built around complicated derivative contracts between banks.
Is this fair? Arguably it’s not the right way to look at it.
Consider how easy toasters are to use. Bread goes in, toast comes out. Set the dial too high, and your toast will burn. But if you were to look inside this modest appliance, you’d find a tangled mess.
Thomas Thwaites tried to build one from scratch, starting by disassembling a £3.99 device. Inside, he found 100 different materials and 400 parts. It took him nine months to make his own.
Generally, we don’t care how our toasters work as long as they do. And people don’t worry about how insurance companies work, as long as they pay out if we make a claim.
Similarly, Ian Lowes, financial adviser and founder of CompareStructuredProducts.com, says: “People criticise structured products for being complicated, but that’s a bit of a red herring. It should be complexity of outcomes that should be a red flag, not complexity of construction.”
On this basis, he says, the possible outcomes of investing in structured products are clearer than most investments, except bonds.
With a fund, it’s impossible to gauge what it will be worth in a year’s time.
With a structured product, the possibilities are clearly defined – if the conditions are met, you get a fixed amount, and if not, the other possible outcomes are also laid out. The key is to understand what these conditions are, how likely they are to happen, and whether you can tolerate the risk.
Lowes adds that even though he’s a strong advocate of structured products (he says they account for half of his own portfolio), they’re better suited as a diversifier for a typical investor.
Questions to ask when choosing a structured product:
Is your capital protected?
Some products will guarantee you won’t lose your initial deposit, others won’t. In exchange for the extra protections of a deposit-based investment, the potential gains are usually lower.
How is the payout worked out?
Ian Lowes advises that all but the most experienced investors should stick to simple products that are linked to the FTSE 100. Some more exotic structured products could be linked to other indices, or individual share performances, which is very risky unless you know what you’re doing.
Are you happy to lock your money away?
You shouldn’t invest in structured products unless you’re willing to invest for the full term, which could be anything up to 10 years. You may be able to sell a structured product back if you need to get out early, but the price you’ll be offered could be less than its maturity value.
Additionally, early exit fees of around £150 to £200 could apply.
Who is the counterparty?
Fundamentally, a structured product is a contract you make with a bank, so you need to be confident it’s going to be able to pay you at maturity. Most are issued by solid banks, and it’s very unlikely that they’ll fail. Not impossible though.
As with anything, if you’re not confident in what you’re buying, don’t buy it. Read the full literature, and if you use an adviser, they’ll be able to help explain the possible outcomes of a structured product.
Read more about how to get investing in 2016.
Moneywise structured product picks:
Investec FTSE 100 Kick-Out Deposit Plan 58 – closes 12/2/16
Potential for 4.25% gross interest on the investment for each year held, payable on any anniversary from year three onwards, provided the FTSE 100 Index – subject to five-day averaging – is above its Initial Index Level.
Meteor FTSE Supertracker Deposit Plan February 2016 – closes 10/2/16
Potential for an interest payment at maturity on the investment equivalent to 1.25 times the rise in the FTSE 100 Index, up to a maximum potential rise of 45% (a maximum potential interest payment of 56.25%). If the Final Index Level is more than 45% above the Initial Index Level, investors will receive a 40% interest payment.
Capital at risk:
Mariana Capital 10:10 February 2016 (Option 1) – closes 10/2/16
Potential for a 7% gain on the invested capital for each year held, payable on any anniversary from year three onwards, provided the FTSE 100 Index closes at or above 90% of its Initial Index Level with a maximum duration of 10 years.
See CompareStructuredProducts.com for full details and current deals.
The practice of a dishonest salesperson misrepresenting or misleading an investor about the characteristics of a product or service. For example, selling a person with no dependants a whole-of-life policy. There have been notable mis-selling scandals in the past, including endowment policies tied to mortgages, employees persuaded to leave final salary pensions in favour of money purchase pensions (which paid large commissions to salespeople) and payment protection insurance. There is no legal definition of mis-selling; rather the Financial Services Authority (FSA) issues clarifying guidelines and hopes companies comply with them.
Structured products offer returns based on the performance of underlying investments. Many products are linked to a stockmarket index such as the FTSE 100 or a “basket” of shares. There are generally two types of product, one offers income, the other growth and investors have to commit their capital for the prescribed term, usually three or five years. The investment is not guaranteed and if the index or basket of shares does not perform as expected over the term the investor might not get back all their capital.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
The Financial Services Compensation Scheme is the compensation fund of last resort for customers of authorised financial services firms. If a firm becomes insolvent or ceases trading, the FSCS may be able to pay compensation to its customers. Limits apply to how much compensation the FSCS is able to pay, and those limits vary between different types of financial products. However, to qualify for compensation, the firm you were dealing with must be authorised by the Financial Services Authority (FSA).
A financial instrument where the price is “derived” from a security (share or bond), currency, commodity or index. The price of the derivative will move in direct relationship to the price of the underlying security. They often referred to as futures, options, warrants, interest rate swaps and contracts for difference (CFDs). They are mainly used for financial certainty – to protect against spikes in the prices of commodities – as a hedge, whereby investors can buy a derivative that bets the market will move against them so they protect themselves against potential losses. Derivatives are also a tool of speculation as they enable banks, traders or investors to bet on price movements without having buy the actual physical assets. As derivatives cost only a fraction of the underlying asset price, they are “geared” (leveraged in the USA) so if the price of the asset moves £1, the value of derivative could change by £10.