There are three main risks attached to structured products, according to Nick Johal, director at Dura Capital.
These are credit risk, market risk and inflation risk.
In terms of credit risk, Mr Johal describes this as “the security backing your investment plan will be issued by a financial institution, usually a bank. In the event of default or bankruptcy of the bank, investors will receive back less than they invested.”
He adds: “Across the board, banks have re-capitalised, repaired balance sheets and have been subject to more rigorous stress-testing over the past 10 years to mitigate the risk of another financial crisis.
"Nonetheless the Issuer should be the first thing an investor in these plans looks at, as they are liable for the return of capital.”
The other two risks are fairly self-explanatory, for intermediaries at least.
A fall in equity markets could lead to investors only receiving a return of their capital, which would equate to a net loss in real terms (inflation risk), while a significant drop in markets could lead to a loss (market risk).
Indeed, many structured product investors have felt the full force of these risks in the past.
The financial crisis in 2008 exposed a number of flaws in the global financial system, and subsequently led to a number of casualties – both big and small.
In the former category, none caused a larger ripple across the globe than the collapse of Lehman Brothers.
The banking giant filed for bankruptcy on September 15 2008, with the effect of its demise continuing to be felt years later.
The relevance of this for this guide is that a fundamental part of Lehman Brothers' collapse was that it had issued a number of ‘structured notes’ that were found to have misled consumers.
According to a research paper by Securities Litigation and Consulting Group, published in 2009, this included a "staggering assortment" of “principle protected notes” such as:]
- 100 per cent principal protected absolute return barrier notes linked to a basket of global indices
- Principal protected note with enhanced participation linked to a basket of commodities
- Return optimization securities with partial protection linked to a portfolio of common stocks
- 100 per cent principal protected notes linked to the S&P 500 index
- 100 per cent principal protected notes linked to an Asian currency basket.’”
Although packed out with jargon, it is fairly straightforward to ascertain the aim of these products, or 'notes'.
Investors can benefit from the performance of a given index or asset, while ensuring that capital is protected.
The report went on to claim that the key issue centered on the 'principle protected' label, which was misused to market structured products which guarantee the return of the 'principle', or in more familiar terms, the original investment.