Protecting your money from the storm

Deciding where to shelter your cash from the ongoing financial storm is a tricky task, so it’s no surprise that products that claim to offer you some of the upside associated with stockmarket exposure, alongside capital protection have proved popular with cautious investors.

The majority of these so-called ‘structured’ products pay back all the initial investment if stockmarkets fall, as well as a proportion of the gains if markets rise. Typically, they are linked to the performance of an index or basket of stocks over three or five years, but the choice is widening and becoming increasingly diverse.

How do structured products work?

Most structured products work by investing the majority of your money into a corporate bond or cash deposit account, which will grow enough to cover the capital guarantee once the product matures. For example, if you were to invest in a five-year guaranteed equity bond, the provider might invest 75% of your money in an A rated bond, paying just under 5% interest a year. By the end of the five years, this bond would have built the 75% up to the full value of your initial investment.

The manager would then use the remaining 25% of your investment to try and generate an additional return. Through the derivative markets, the managers can leverage their position – meaning that they need only to invest a small amount to get a large exposure to an index or stock.

In theory, structured products offer the best of both worlds, as you can participate in any growth in the stockmarket, as well as benefit from the comfort that your original sum will be returned. However, the demise of Lehman Brothers, an investment bank that backed some of these products, in September 2008 demonstrated that investors must be wary of any product that claims to offer capital protection.

Certainly the current murky market conditions have made it an ideal time for providers to launch a flurry of these products. This year alone, a staggering 800 structured products have been launched, compared with 740 over the whole of last year, according to Keydata, a specialist provider of the products.

Whether they’re linked to agriculture, indices, or even bombed-out banking shares, new structured plans are coming onto the market fast. Yet, while what they promise can be seemingly simple, the detail can prove harder to understand.

What you need to know

Before considering any recent launches, it’s important to contemplate the general drawbacks of these investments. For starters, structured products do not pay dividends, which account for about 20% or 30% of the total return of investing in the FTSE 100, stresses Meera Patel, senior investment analyst at IFA Hargreaves Lansdown.

Also, even if your plan does guarantee your capital, structured products are not necessarily a means of beating inflation. Despite their promise to ‘protect’ your investment, remember that your original capital will be eroded in real terms over the product’s life span if it doesn’t make a return.

“Choosing one of these plans can be difficult,” says Geoff Penrice, senior adviser at Bates Investment Services. “Often they appear to be offering something which is too good to be true and, as with life in general, if it seems too good to be true, it usually is.”

Some products will lock in any gains each year and offer a way of participating in various markets while reducing the downside risk. Other innovative structured products are looking to cash in on current.

“One of the problems with the current onslaught of products at the moment is that some, like this, are a bit gimmicky,” says Brian Dennehy from IFA Dennehy Weller. “Structured products may be attracting more interest, but they’re losing the beautiful simplicity that they had.”

However, they can be a means of reducing investment risk and diversifying your portfolio, he adds. “We’ve always been fans of structured products provided they fall within certain criteria – a clear 100% guarantee or protection, alongside a very clear formula for calculating the final return,” says Dennehy. “They remain good for those wanting to reduce building society exposure, say, but not comfortable with day-to-day stockmarket risk.”

Some advisers remain unconvinced of their merits, preferring to mix and match assets using traditional products for a diversified portfolio, or use simple savings accounts. Patel says: “Generally, we feel that if you want a guarantee of some sort you should stick to deposit accounts, as at least you’re guaranteed to get some form of return on top of your capital.”

Dennehy adds: “When structured products become too complex, with too many bells and whistles, it could be better to put some money in the stockmarket, with a larger percentage in a good corporate bond fund to provide a balance and reduce risk.”

The charges on these products are built into them, but they can cost up to about 7.5%, so check this carefully. “If you’re getting decent exposure after charges it shouldn’t be a problem,” says Dennehy. “Make sure, however, that you’re not paying high charges for a product that has limited potential with growth capped at a low level.”

Think before you sign-up

Vitally, ensure that you understand how the product works before signing on the dotted line. “There have been very few structured products that I have come across over the years that have delivered what they say on the tin,” says Patel. “You also need to bear in mind that structured products which are linked to an index can be skewed.”

Patel adds: “You need to ask yourself if it’s better to be selective when it comes to the underlying stocks and if you’re going to get the right level of diversification.”

Investors have been caught out before – thinking that their capital was safe, only to discover that, under the terms of the plan, it was at risk. Back at the start of the decade, British investors lost thousands of pounds in products such as these, known as ‘precipice bonds’. These high-income bonds which were linked to various stockmarket indices, offered an income in excess of that offered by conventional savings accounts but offered little in the way of capital protection so, when the stockmarkets collapsed, investors’ savings were wiped out.

The schemes were aggressively promoted to low-risk investors like the retired and many did not realise their money was at risk. As a result, a variety of financial services companies including Lloyds TSB and Bradford & Bingley were fined for mis-selling.

However, the market has moved on and the industry has learnt from its mistakes. “The way these products are marketed has improved a lot since the precipice bond debacle, and providers are less inclined to use the word guaranteed,” says Penrice.

So, if the security of your capital is your main reason for choosing one of the plans, double check that it promises to repay 100% of your capital on maturity – irrespective of what happens in the stockmarkets.

Some structured products are far riskier than others, making it possible to lose a much greater portion of your investment if the underlying index or basket of stocks falls by a certain amount.

For example, there are growing numbers of products that guarantee your money as long as the underlying index doesn’t fall by more than 50% during the lifetime of the investment. Thereafter, you could see virtually everything wiped out.

This means it’s also vital to check whether a third party has been required to guarantee the investment. “Watch out for whether a product says it’s ‘guaranteed’ or ‘protected’,” says Dennehy. “If it’s guaranteed, then the provider whose name appears on the brochure will be covering it, like Barclays’ plans, but if it’s protected, then often what’s known as a ‘counter-party’ will be behind the product.”

However, the counter-party’s identity is not always advertised. “Typically this has been unclear, as the contract the provider has with the counter party may mean they are unable to say who they are, which will provide little comfort in this environment. It’s always worth asking though, as what happened with Lehmans could happen again.”

While some of these investments still have a place in some investors’ portfolios, it’s worth noting that they are more commonly sold in the direct market than via financial advisers.

And if you reckon that they are an easy way to have your cake and eat it, you should proceed with caution. Never has it been more important to read the small print and get a firm idea of just exactly where your money is being invested.