How to invest using structured products: a beginner's guide

Beginner's guide to structured products

A structured product is a generic term to describe a type of investment that usually has a fixed term, offers some capital protection and, subject to various conditions being met, pays a predetermined return on capital. A few years ago they were being actively promoted by banks and building societies, but a series of scandals in the wake of the financial crisis and some regulatory attention means they are becoming less common on the high street, although they are still widely available through other channels.

In essence they are investments whose returns are based on the performance of an underlying index or basket of shares. They can be called a variety of names - guaranteed equity bonds, structured cash Isas, protected investment bonds and growth deposit plans are some of the more common descriptions.

There are two main types: structured deposits and structured investments.

Structured deposits, as the name suggests, are deposit accounts; but unlike conventional accounts, where the rate of interest depends on prevailing base rates, their returns are linked to the performance of some other index or asset, commonly the FTSE 100. So the return may be a multiple of the performance of the FTSE 100 – say 120 per cent of its rise – usually with a cap; or it will promise a specific rate of return – say 6.5 per cent a year – provided the index rises by a particular amount. Some pay nothing if the index falls below a set figure, but your original investment is secure.

As deposit accounts, these will often be covered by the Financial Services Compensation Scheme, which protects deposits up to the value of £85,000. The rest of this article, therefore, mainly refers to structured investments, which do not have such guarantees.

Structured investments are also generally linked to an index. Some products have capital protection, which means investors will not lose their initial stake (but see counterparty risk below); others put the initial capital at risk. They have a fixed term, although some pay out early if the predetermined targets are reached.

There are many types of product. Some offer a preset annual return provided the FTSE 100 rises each year; others promise a fixed return if the index never closes below a set level during the life of the investment; others again pay returns based on the performance of a number of different indices or baskets of shares. Returns can be paid annually, as income, or when the term ends.

The products work by using derivatives. The initial investment is divided three ways: to buy into a savings product designed to return the capital at the end of the term; to buy a financial instrument that will produce the promised return; and to cover the provider’s fees.

What to be aware of

Many investors are unaware that these products have what is known as counterparty risk, in that they are effectively loans to an investment bank (whose identity may only be revealed in the small print and may be different from the firm promoting the product). The bank provides the investment and derivatives behind the product, which means the investment is heavily dependent on the financial stability of that bank.

Advantages include the fact that when interest rates are low, stock markets volatile and bonds (particularly investment grade and gilts) looking expensive, the returns available on structured products can be attractive. Additionally, the range of structured products available means investors can tailor a portfolio of structured products to reflect their risk appetite and time horizon.

Many structured products offer some downside protection, so investors’ capital will only be at risk if the chosen index falls by more than, say, 50 per cent and losses will be tapered after that, depending on the extent of the fall. Moreover, the return on growth products may be treated as a capital gain subject to capital gains tax (CGT), rather than income tax.

However, structured products can be illiquid. There is a secondary market for some structured products but not all, and investors may not get all their original investment back. They can also be expensive: charges of 7 per cent or more are not uncommon.

Risk is another issue. While betting that the FTSE 100 will rise by a set percentage each year may not sound that risky, the experience of the past 10 years shows just how volatile markets can be. And there is a limited upside with potential returns capped, so if markets soar, investors will not reap the full benefit.

Things to consider before you buy include the stability and credit rating of the counterparty; the level of risk (more indices means greater risk); how realistic performance targets are; how much you could lose; tax treatment (income or capital gains?); charges; and penalties.

We make every effort to ensure our beginner's guides are kept up-to-date. However, in the constantly shifting environment of investment and financial services, occasions may arise where elements of a guide become out-of-date. Please double-check the facts before taking any important financial decisions.


Subscribe to Money Observer magazine

 

Comments

Post new comment

The content of this field is kept private and will not be shown publicly.
By submitting this form, you accept the Mollom privacy policy.