Stockmarket returns without the risk

Published by Rebecca Atkinson on 28 January 2008.
Last updated on 23 August 2011

Woman on sofa

There are some things in life that you’d love to have, but they’re not quite right for you. You may love a Great Dane but live in a shoebox, or fancy a holiday in the Bahamas but you’re terrified of flying. You don’t have a choice, you simply have to accept your limitations and buy a gerbil or a fortnight in Scarborough.

Many people feel the same way about investments. They’d love to get a bit of the growth they’ve heard everyone talking about, but they don’t want to lose their shirt. However, there is a breed of investments that claims to offer the best of both worlds – structured products. They say they’ll offer a portion of the growth of an index or asset, without you risking a penny.

There are hundreds of different types of structured products, but the most popular offer some sort of share in the gains of the UK stockmarket over a fixed period of time. And if, for any reason, the market should fall in that time, you won’t lose any money. Hence the ‘best of both worlds’ claim.

The concept is appealing because investors can see the huge waves of volatility rocking the market. They know the markets have done well for years, and don’t want to miss out on any potential gains in the future, but they are looking for some sort of life raft if things should go wrong. It appeals to low-risk investors, who may be people who are retired and don’t have any other money to invest, or simply those who would be kept up at night by the thought of anything more daring.

It pays, of course, to know whether your life raft is seaworthy. But the only way to do this is to understand what lies under the wrappings of your structured product. Unfortunately, although these products are very simple on the surface, underneath they are about as complicated as they come, says Donna Bradshaw, financial planning strategist at IFG Financial Services.

“It can be challenging for market professionals to deconstruct these products and measure the risks and costs involved, so private investors should approach this with caution,” she adds.

Their performance promises are linked to an index or stock, but they don’t actually invest in them. Instead, they are created using derivatives, including options, forwards and swaps – the kind of investment instruments that most investors wouldn’t touch with a bargepole.

They are essentially a geared bet on which way the market is going, and can be structured to pay off if the market gains, and still breakeven in the event of it falling.

In theory, if any of the counterparties of these derivatives (in other words the people you are making the bet with) renege on their commitments, your guarantee could be under threat. In reality this is only a problem if your structured product provider fails to step in and cover the difference. It’s worth checking, therefore, who your product provider is.

This is easier said than done, because often the companies fronting the product, such as Barclays, aren’t actually running it. Nor will they tell you who the provider is until the offer period is closed. However, they will tell you their credit rating, which indicates how risky they are judged to be. Most are AA rated, so there’s very little risk of them failing to live up to their guarantees. But it pays to be certain of the credit rating of the company behind any product you consider.

However, even with a reliable guarantee these products aren’t perfect, says Patrick Connolly, an adviser with Towry Law. “We have never used structured products. You are always giving up something, and I’ve never come across a product where I’ve thought that’s a price worth paying.”

Guaranteeing your money back if things go wrong sounds good, but if that’s the situation you end up in, you’re actually missing out.

Adrian Cravchinsky, joint director of the structured product division of London & Capital, explains: “With capital protected products it’s the opportunity cost of the income you would have had if you had invested in different instruments.” This includes the interest you would have earned on a bank deposit, for example.

You also miss out on the dividends you would have received if you had invested in the stock directly, says Matthew Woodbridge, bond manager at Chelsea Financial Services. “If it’s the FTSE, for example, dividends are around 3%. That’s how they can offer something like 200% of the FTSE 100 with 50% capital protection.”

This is why many financial advisers prefer to construct their own diversified portfolio, points out Connolly. “You can put together the right mix of assets to match the risk appetite of the investor, and get the maximum return because you’re not paying for protection.” Alternatively there are other products that offer stockmarket exposure with reduced risk such as cautious managed funds, UK equity income funds and savings.

But fans of structured products claim other advantages. Firstly, you can get products linked to a whole variety of indices, including commodities such as gold, and overseas markets such as China or the US.

“They are used to diversify the portfolio and provide exposure to other asset classes,” says Cravchinsky. “They can also provide access to stocks they may not otherwise have access to, but with some form of capital protection.”

Woodbridge cites the Morgan Stanley Emerging Market Growth Plan as an example of this. It offers full return of capital and up to 75% of the growth in the BRIC (Brazil, Russia, India and China) economies. “You get exposure to risky, volatile markets, you can do well if they do well but you don’t lose your shirt if things go wrong.”

In fact, there are so many different types of these products around that investors can find one that claims to do exactly whatever they’re after. Robert Bell, the other joint director of the structured products division of London & Capital, says: “We can enhance products by giving them characteristics they do not usually have, such as an income stream.”

Others can be structured to offer less protection in return for more upside. These products, which put your capital at risk, hit the headlines five years ago with the precipice bonds scandal. These offered a geared upside to the market, but if it fell beyond a specific point, the bonds fell at a multiple of any falls in the stockmarket. Sure enough, when the dotcom crash brought the markets down, these products crumbled.

But things have changed since then, Bell insists. “There was mis-selling behind precipice bonds as people were not warned about the full nature of the risk. That was five years ago and regulation has moved a long way since then.”

Now, says Ronan Gelling, marketing manager with structured product provider NDF, “people are less afraid of capital at risk products and there are more out there. Precipice bonds had a geared downside and nobody touches those any more.”

Others are far more complicated, according to Gelling. “We did a ‘kick out’ plan, which was for six years, but if the index does something, the plan matures early,” he explains. The plan, linked to the FTSE and Nikkei, offers redemption after one year at 16% return if both indexes are at or above the starting points. If they aren’t, it rolls over to the next year, and so on until the sixth year. If it doesn’t pay, the investor gets their money back.
One of the many designs of structured products may suit your needs, or you may consider that it’s not worth the cost.

As Bradshaw points out, just as these things look more attractive, they become less so: “With markets as flighty as they are now it makes the hedging strategy for structured products that much more expensive.”

So you can find a breed of Great Dane to fit in your shoebox, and you can bring Barbados somewhere just round the corner. But you’ll pay a price for it, and only you will know whether that price is worth it.

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