Is your money really safe?
The collapse of US investment bank Lehman Brothers showed that an alarming number of structured products were making promises which were literally too good to be true. Now, the industry’s fight to prove that it can offer low-risk, high-return products is being undermined again, this time by the turbulence in Europe.
Will the latest concerns over the health of the banking sector spell the end for structured products?
While the name may not be familiar, the products almost certainly will be. More than £42 billion is invested in these products, which are promoted by virtually every bank and building society as a way of getting equity-type returns without the risk.
Their names sound reassuring – Target, Protected and Guaranteed are typical words – and their offering sounds simple enough: you get a certain percentage of the rise in the FTSE 100 or a similar type of index, which can be as low as 10 per cent or as high as 200 per cent. If the index falls, however, you will get all, or most, of your money back.
Yet the structure behind these products is far more complicated – a complexity which explains why so few investors and advisers were aware of how risky they were. Exposure to the underlying asset class is often achieved through a derivative product issued by an investment bank. The guarantees are also usually achieved through a financial product issued by an investment bank.
As the collapse of Lehman Brothers in 2008 showed, a derivative is only as good as the bank which stands behind it. Thousands of investors lost out last year as companies such as ARC Capital & Income, NDFA and DRL, all of which used Lehmans as counterparty, went bust. Then Keydata, which supplied structured products to many banks and building societies, collapsed amid a Serious Fraud Office investigation.
These disasters sparked a rather belated investigation into the structured products industry by the Financial Services Authority. As well as paving the way for investors who had lost money to make claims under the Financial Services Compensation Scheme, the regulator wrote to the biggest promoters of these plans telling them to review their sales and marketing procedures. The FSA is still investigating the area and is expected to announce its findings by the end of the year.
Structured product providers reacted by insisting they should not all be tarnished by the Lehman connection, citing a range of reasons that they were different: they use only top-rated banks as counterparties; they spread the risk among a number of different banks; they use government bonds to back their promise; their products are conservatively managed and so on.
Their protestations have had little impact: in our sister publication, Money Observer’s own, admittedly unscientific, survey of financial advisers, none would recommend structured products. While they cited a variety of reasons, one was constant: it is impossible to assess the credit risk in these products without carrying out far more analysis and investigation than financial advisers are willing, or usually qualified, to carry out.
Perhaps because of the failure of that campaign – or possibly because they fear a bigger crackdown by regulators – the industry has gone to ground. Leading players such as Barclays and Morgan Stanley refused to be interviewed by Money Observer and even the UK Structured Products Association, the trade body set up to promote the industry, struggled to come up with a response to our questions.
That is extremely worrying because, while Lehman’s collapse may be fading into history, credit risk remains a major issue – in fact, it could soon be thrust back to the top of investors’ worries. The Greek crisis has turned the spotlight on to the financial health of Europe’s banks again. There are constant rumours about which banks are dangerously exposed to the debt of the Greek government, or to that of Spain and Portugal, which are in almost as parlous a financial position.
Investors were particularly nervous ahead of the publication of the results of a ‘stress-test’ of Europe’s banks, being carried out under the auspices of the European Central Bank. The impact of a sovereign debt crisis is likely to be one of the key variables which banking regulators will be testing for.
Martin Bamford, managing director of Informed Choice and a chartered financial planner, warns: "The eurozone crisis could trigger further bank collapses which could undermine the backing of some structured products in the UK. The trouble is, it is close to impossible to understand where the financial protection actually rests with a structured product."
Tim Cockerill, head of collective investment research at Ashcourt Rowan, agrees. "It is clear there are significant stresses in the [European] banking system. Counterparty risk is a big issue. Recent experience has shown that [a bank] can be rated highly but the reality is different."
Robert Lockie, a partner in Bloomsbury Financial Planning, says: "I have not got the time, and I suspect most advisers do not, to go and dig into the detail of the operations of the guaranteeing banks and to ferret out the potential liabilities which might be lurking there. A lot of derivative instruments are not on the balance sheet anyway.
"And your bank may have no derivative exposure but it may have lent to other banks which do. And you have to monitor changes in the future. Is it worth doing all that for a £50,000 investment in a structured product?"
The fact that guarantees underwritten by banks can be unexpectedly flimsy is not the only – or even the major – reason for avoiding structured products. There are plenty of other drawbacks too.
It is impossible to work out what your investment will be worth. The products promise a return of, say, 50 per cent of the gain on the FTSE 100 between two dates but, apart from the impossibility of forecasting what that gain will be, different providers calculate the gains in different ways. And, for much of the past five years, there has been no gain so investors will have had to fall back on the guarantee that they will get just get their money back – so why lock yourself in and pay the costs of these products to get a return worse than a building society?
"It is an extra layer of complextity which does not have much practical benefit," says Lockie. "If you want a return half as as much as the FTSE 100, just invest half your portfolio in it."
Of course, anyone buying a unit or investment trust is also buying blind as no-one can predict how they will perform. But it is easy to buy and sell these trusts; with structured products, investors are locked in for a fixed term and could face big losses if they try to get out before the product matures. And, while some products lock in returns as they go along, others can be severely affected by a sudden stock market crash just before they mature.
"They are sold by banks and building societies – that tells you all you need to know," says Mark Dampier, head of research at Hargreaves Lansdown. Indeed, many of the mis-selling scandals of recent years – like precipice bonds, endowment mortgages and payment protection insurance – have been products which are sold mainly by banks and building societies.
"I have never seen anything I particularly wanted to buy which has a fixed investment term – I want something I will be able to roll over," adds Dampier.
He also points out that structured products generally pay no income during their term. "A dividend is a massive part of investment returns, if you take the dividend away, you take away a big chunk of these returns."
While charges are rarely spelled out in detail, the complex structures and expensive guarantees mean they are an expensive way to invest. The lack of transparency about these costs is indicative of how complicated they are.
"My over-riding view is that, the simpler and more transparent a product is, the better," said Cockerill. "That way, you do not risk unpleasant surprises."
The Investment Management Association has complained that these products carry far fewer restrictions about the way they are sold, and how they can be marketed, than unit trusts – yet they have been shown to be far riskier.
The irony is that, when the measures outlined in the Retail Distribution Review, which governs how advisers must behave, come into effect in 2012, advisers will have to consider structured products for their clients.
"Our view here is that we can take a view generally as a firm that we will not use them, giving reasons," says Lockie. "If a client wants them we will have to tell them to go elsewhere."
This article originally featured on our sister publication's website - moneyobserver.com.
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.
The term is interchangeable with stock exchange, and is a market that deals in securities where market forces determine the price of securities traded. Stockmarket can refer to a specific exchange in a specific country (such as the London Stock Exchange) or the combined global stockmarkets as a single entity. The first stockmarket was established in Amsterdam in 1602 and the first British stock exchange was founded in 1698.
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.
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
The Financial Services Authority is an independent non-governmental body, given a wide range of rule-making, investigatory and enforcement powers in order to meet its four statutory objectives: market confidence (maintaining confidence in the UK financial system), financial stability, consumer protection and the reduction of financial crime. The FSA receives no government funding and is funded entirely by the firms it regulates, but is accountable to the Treasury and, ultimately, parliament.
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.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
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.
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.