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.
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.
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.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
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.
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.
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.
This is more usually a feature of car insurance but it can also crop up in contents, mobile phone and pet insurance policies. An excess is the amount of money you have to pay before the insurance company starts paying out. The excess makes up the first part of a claim, so if your excess is £100 and your claim is for £500, you would pay the first £100 and the insurer the remaining £400. Many online insures let you set your own excess, but the lower the excess, the more expensive the premium will be.
This is a mutual organisation owned by its members and not by shareholders. These societies offer a range of financial services but have historically concentrated on taking deposits from savers and lending the money to borrowers as mortgages, hence the name. In the mid-1990s many societies “demutualised” and became banks. One academic study (Heffernan, 2003) found demutualised societies’ pricing on deposits and mortgages was more favourable to shareholders than to customers, with the remaining mutual building societies offering consistently better rates. In 1900, there were 2,286 building societies in the UK; in 2011, there are just 51.