Your IndustryOct 31 2013

Pros and cons of structured products

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Mr Lowes says: “The qualities of structured products - defined outcomes based on defined market conditions, plus potentially a degree of capital protection, and the ability to deliver in flat or even falling markets– means they can be useful tools for adviser looking to achieve balance and diversification in investment portfolios.

“Structured products also can be used to take a view on the markets – for example, an adviser who believes the markets will go up but not by very much over the next year might buy an autocall which has the potential to mature early (on an annual anniversary) to deliver a potential gain and return capital, allowing reinvestment into another product or fund at that time.

“Similarly, an adviser who believes the markets may range trade, might buy a defensive structure that gives, for example, a set return if markets fall anything up to 20 per cent over five years.”

As with any investment there are risks involved with structured products.

Counterparty risk is the possibility that the counterparty to the product might go bust and not be able to meet its contractual obligations.

Mr Lowes says no one can say that a bank will not fail but use of credit rating agency ratings, looking at CDS spreads and, if an adviser wants to go that far, looking at bank balance sheets, can help mitigate the risk.

Market risk is another factor.

There is always the possibility that markets might fall so far that protection barriers are breached and investors will lose capital - although Mr Lowes points out typically barriers are set at 50 per cent of the index strike point and if the stock markets were to fall by that large a figure then markets would be in crisis and all other investments would also be massively affected.

Another market risk is that at maturity markets are down and no gain is achieved so only capital is returned, in which case inflation may have eroded the real value of the capital.

However Adrian Neave, managing director of Gilliat Financial Solutions, says one of the benefits of structured products is they are relatively straightforward for investors to grasp.

Structured deposits are like straight forward bank deposit accounts, according to Mr Neave, with the difference being interest is calculated by reference to a formula.

An example might be that there will be an interest payment of 5 per cent as long as the FTSE 100 is more than the level it was at when the original deposit was made.

The level of the index might be observed every 12 months and if it is higher the client receives interest of 5 per cent, if it is lower no interest payment is made.

Mr Neave says the attraction of structured deposits is they will typically offer potentially higher interest than conventional term deposits, however there is obviously the risk of there being no interest if the reference asset does not perform.

He says these products are popular also because they attract coverage under the deposit side of the Financial Services Compensation Scheme, meaning that investors (assuming they qualify) would be covered up to £85,000 should the issuing bank fail.

The one ‘disadvantage’ of structured deposits, according to Mr Neave, is that any profits will be subject to income tax, whereas structured investments are often treated under capital gains tax, which is often more attractive from the investors’ perspective.

Structured investments are not covered by the FSCS, however Mr Neave says the advice regarding investing in them is, so if an investor feels they have been mis-sold they may still be able to register a claim through the Financial Ombudsman Service.

Structured investments come in two forms, capital protected or capital at risk, Mr Neave adds.

Capital protected products work in the same way that structured deposits do, the difference is that they may be constructed so that any profits arising are subject to CGT as opposed to income tax.

Mr Neave says: “It is important to check the wrapper for the product to establish the tax treatment, enterprise investment schemes may not be eligible for CGT treatment where dual warrant constructs may be; however it should be noted that warrant structures would not be eligible for inclusion in Isa.

“Capital at risk products generally offer higher returns than structured deposits or capital protected investments but investors do put capital at risk.

“Usually markets would have to fall considerably, typically by 40 per cent or more before an investor would lose money but once the level is breached losses will normally be on a one for one basis.”

Ultimately Mr Neave says retail structured products will usually protect investors against all but savage falls in the reference asset.

He says: “The most common reference in the UK is the FTSE 100 and capital at risk products will usually return 100 per cent of an investors’ capital unless the index has fallen more than 40 per cent.

“For risk adverse investors this can be an attractive feature, allowing participation in equity market growth while managing the downside.”

One of the biggest issues the structured product industry faces, according to Mr Neave, is ill-informed comment from so called experts dismissing structured investments as being highly complex.

He says: “This is incredibly naive and shows a complete lack of understanding of the mechanics of structures.

“It is essential to understand that there are two sides to a structured product; there is the asset the investor buys, and there are the actions a bank takes to hedge their liability to investors.

“In the vast majority of cases the investor will be buying a senior unsecured note. This is a corporate bond where the interest payment is dictated by a formula related to something like the growth in the FTSE 100.

“This sits as liability on the issuer’s balance sheet. They will owe the client whatever the defined returns are at maturity whatever happens.

“The bank itself will buy and sell derivative contracts and fixed interest securities that together create the returns that they are obligated to pay the client. However the client does not ‘own’ any of these securities.

“Theoretically the bank could take investors’ money and put it on the 4:30 at Chepstow and lose it all. At the end of the term they will still owe the client the returns promised from the product.

“The fact that they have ‘spent’ the investors’ money is irrelevant. Of course in real life the regulators might have something to say about such cavalier management of a bank’s balance sheet.

“Hopefully though this illustrates the reality of the relatively simple (compared to say absolute return funds or with profits) asset the investor buys and the undoubtedly complex actions a bank will be taking to ensure that they are in a position to meet their liabilities.”

But Graham Devile, managing director of Meteor Asset Management, says a structured product is not a savings account, nor is it a magic route to attractive returns in a low interest environment.

He says: “When you invest in a structured product, you are generally consenting to accept a degree of risk in exchange for the potential to receive a return which is higher than the risk-free interest rates available.”

But Mr Devile says these products can modify risk by acting as a hedge against an existing portfolio exposure.

He says: “If clients are long or short equities, structures can be used as a hedge against their positions.”

Plus despite the perception that structured products are illiquid, Mr Devile says this is not the case.

He says: “It is now common, under normal market conditions, for the counterparty to act as a market maker, offering fair value for the underlying securities and creating a secondary market.

“While this is not guaranteed, in normal market conditions it would be unusual for this not to be the case.”