Providers of these products responded in a number of ways. Whilst some saw it as an opportunity to protect investors’ funds, others saw it as an opportunity to make money due to how opaque these products are.
Here at Worldwide, we are happy to advise you on your investments and portfolio. We hope this information gives you sufficient guidance to understand fully how structured products actually work. With this knowledge, you should avoid any loss of capital and maximise the returns on your investment.
If you would like a free initial meeting with one of our FT award winning advisers call in confidence now on 0800 0112825 or complete the contact form and your dedicated adviser will call you straight back.
The following are the questions we will answer below:
- What is a structured product?
- Are structured products clear and transparent?
- How do you ascertain a structured product’s charges?
- What risk are structured products?
- What do you lose out on when investing into structured products?
What are structured products?
Structured products are plans prepared by a product provider.
Unlike a normal investment where you buy shares or property directly, these arrangements tend to buy a range of complex instruments to achieve their objectives.
For example, structured products may offer 80% of the return of the FTSE all share index as long as the FTSE all share doesn’t fall by more than 50% and not recover.
In order to achieve this, the company buys a ‘promise’ from a provider (counterparty) such as RBS, Lloyds etc which provides an annual return, which in turn provides the capital protection at maturity.
In simple terms, if the annual return was 6%, the provider of the structured product might have to place c75% of the original investment with the counterparty and that would provide the 100% capital return after the five years. The remaining 25% will go towards a mixture of charges and the purchase of complex derivatives in the stock market. It is this 25% which provides the 80% upside return example above.
Are structured products clear and transparent?
Structured products are as transparent as a political manifesto.
How will an investor know how to ascertain the true risk of an investment and how will they really know if the derivatives are likely to be successful?
What is the true risk of the counterparty? Are they really likely to be able to make the appropriate returns or will they default?
What are the true charges for example, as they are never evident?
In the structured product’s documentation, normally called key features, there will be a reference to these risks but it is nothing that you will be able to make a judgement on as it is never relative. Very few advisers would be able to take a view, let alone an inexperienced investor.
How do you ascertain a structured product’s charges?
This is the clever bit as far as structured products are concerned. You will just need to look at the profits banks are making to see what the true charges really are.
Most structured products are sold with the ‘there is no explicit charge’ line, which is true but not really representative of what investors will read into it. They will read it as no charge at all but most of the charge is hidden in the returns you will receive.
To be simple, if they have offered you 80% of the return of the stock market, where is the rest going? This is the easiest place for them to hide expensive profitable charges and there is no regulation in place yet to ensure this is clear to the customer when it comes to structured products.
What risk are structured products?
There are various risks to you as an investor with structured products but the primary risk is that of the capital return at the end.
The biggest risk lies with the counterparty, as described above. If they default, your capital return is non existent. Moreover, unlike with normal investments where you can then rely on the Financial Services Compensation Scheme (FSCS), these plans are not covered as they fall under a complex piece of legislation called the large company rule.
Lehman's and other investment grade organisations have gone belly up in the past leaving the investor with an empty account. With a normal investment such as a unit trust, if the unit trust provider goes ‘belly up’ your assets would be ring fenced.
The biggest issue with structured products is the fact that they are aimed at investors who do not understand risk, are risk averse and yet the return depends on the survival of just one organisation – the counterparty.
It is now a requirement that a firm researches the risk of a structured product and decides on its suitability before allowing their advisers to ‘sell’ it.
The FSA now expects that advice on structured products should be given in the knowledge that investment grade counterparties can fail.
How can an adviser assess that risk? There are a few options an adviser can use to do that, but ascertaining the risk rating from Standard and Poor’s is one, as well as Moody’s and Fitch (Credit Rating Agencies). Also the adviser should understand the counterparty risk and understand the geographical implications of that counterparty risk.
Financial ratings and credit default swaps are the two key components as well as the geographical issue as above, but advisers also have to look at the trend of the counterparty risk i.e. is the financial strength of the firm rising or falling.
What do you lose out on when investing into structured products?
Well lots really. Structured products do not allow you to benefit from the dividends that are paid by a company. If the FTSE is providing 3-4% dividend income as it has been, you will be losing out significantly. Over five years this is 15-20% return you will have missed out on. Few are aware of this.
Many structured products include a mechanism to protect the provider of the plan called a ‘kick out’ option. This refers to a plan that auto-matures if a market performs by more than a certain percentage. They used to be marketed differently but (and I believe I may be able to take the credit for this) I wrote about them seven years ago saying they simply kicked you out of the party when it was about to get started.
They work on the basis that if a market returns ‘x’ your plan auto-matures and you receive a set amount. This is singly the biggest rip off in financial services history and is poorly understood by all parties. It is there to ‘protect’ the market maker or structured products designer to ensure a maximum return. It is not there to protect you, the investor.
Stock markets do not make returns on a consistent basis. In some years they perform really well and in others they do not. In some years they fall and in some years they rise by large percentages. So, let’s say the market falls by 3% in one year and then rises the next by 25%.
In a kick out plan option you would have been dumped out of the market at a prescribed amount (typically c8% return) i.e. much less than the 25%. You would now have to re-enter the market at a much higher price and then pay hidden product fees (c3-6%) on top of this – and you have missed out on the dividend yield (c3% on average) in that year so are probably over 20% worse off.
I listened to an adviser recently who was chuffed that in 2009 he had sold £5m of these structured products schemes and their customers were over the moon because they had received 12%. The market was up over 30% and they had missed out on that extra 18%.
Had it been explained to the customers what they had missed out on they would not have been so happy.
Worse still they may now have to go through a new set of charges and commissions.
With kick out points at the level most are set at, it’s difficult to see how anyone might consider them at all.
There are a range of other issues and risks to consider with structured products, but space (and your concentration) prohibits coverage of them.
However, in a whistle stop tour, beware of any product designed for less than five years, any product with downside gearing, excess averaging, and links to an index or basket of products that are unsuitable.
In summary, structured products are sold as simple risk averse contracts, but are probably one of the most complex contracts you will ever begin to understand and the risks are often masked by front page marketing drivel.
Most mainstream structured products at the banks are highly profitable for the bank in their makeup where they offer relatively poor participation in the market.
Risk comes from knowing what you are doing, or knowing someone who knows what they are doing.
It is all about understanding the potential for what might happen and you will need a specialist Independent Financial Adviser to do that.
To access our investment advice, call your FT award winning adviser in confidence now on free phone 0800 0112825. Or complete the contact form and your dedicated adviser will call you straight back.
