Can structured products really shield investors' gains from stock market setbacks?

Protecting investment portfolios with a shield

Brokers have been issuing structured products since the 1980s. They were initially sold only to institutional investors because of their complex nature; however, by the early to mid 2000s they had increasingly found their way into private investors' portfolios.

Designed to protect initial capital except in the event of a significant market fall, and providing a known return at the end of a fixed investment term, they proved attractive to market-shy investors.

However, in 2008 the risks involved in structured products were made startlingly clear when Lehman Brothers - which had underwritten $18.6 billion (£12.3 billion) of structured products - went bust, leaving investors in the vehicles with no other choice than to join the long queue of creditors seeking repayment.

'KNOWN OUTCOMES'

Structured products' promise of 'known outcomes in known circumstances' still attracts investors. According to Ian Lowes, financial adviser and founder of comparestructuredproducts.com, over 1,750 structured products have reached maturity in the advised space since 2009.

In that time, Lowes says that products sold by advisers returned an average of 5.9 per cent a year, while those in the top-performing quartile delivered close to 12 per cent.

He comments: 'We have been using structured products in our client portfolios since the early 1990s, and while past performance is not a reliable indicator of future performance, they have helped to enhance portfolio returns while at the same time providing protection against stock market falls.'

Structured products fall into two categories: structured deposits and structured investments.

Structured deposits are akin to fixed-term cash deposit accounts, but instead of interest being earned at a set or variable rate, the return is fixed. Like all structured products the return is determined by the performance of a specified benchmark, typically the FTSE 100.

For example, a deposit plan might pay 30 per cent when it matures, if the FTSE 100 is above the level it was at when the plan started. If it is below that level, it will return capital only.

KICK-OUT PLANS

Structured deposits are designed to return investors' original capital as a minimum, and like most UK deposit accounts, they usually benefit from Financial Services Compensation Scheme (FSCS) protection should the counterparty go bust.

Structured investments, however, do not guarantee capital protection. The most common type of capital-at-risk structured product is called an auto-call or 'kick-out' plan.

As with other structured products, these have a maximum term usually of six years, but have the potential to mature on specific anniversary dates. For example, a plan may pay 8.25 per cent a year, with the ability to mature or 'kick-out' on any anniversary from year two onwards if the FTSE 100 is at or above its starting level.

If the FTSE 100 is lower than the starting level on each anniversary, the plan will continue until maturity. If at this time the index is still below its initial level, but not more than 50 per cent below it, the plan will return capital only.

If the index is more than 50 per cent below its starting level then investors will lose capital on a 1:1 basis, i.e. if the index is down 60 per cent, investors will lose 60 per cent of their capital.

Structured growth plans run to full maturity, again usually six years, and offer either a fixed return depending on the performance of the index, or geared participation in the same performance up to a limit. For example, a growth plan may offer a gain upon maturity equal to five times any rise in the FTSE 100 from 90 per cent of its initial level, capped at 60 per cent.

If the index when the plan matures is at or below 90 per cent of its initial level, but not more than 40 per cent below, capital will be returned. If it is more than 40 per cent below that initial level, investors will lose capital on a 1:1 basis as above.

Less common are income-oriented structured products which will pay a fixed amount monthly or quarterly, on either an auto-call or a fixed-term growth basis, should the underlying index be at or above its initial level, with capital loss barriers similar to that of auto-call and growth products.

PROTECTION VS OPPORTUNITY

Clearly, structured products are not simple investment vehicles, but they do offer a certain level of protection. The deposit type, where capital is fully protected by the FSCS, is of course the safest option.

Delivering annual returns most often in excess of 5 per cent should the underlying index rise, these products are arguably an attractive alternative to fixed-term cash deposit accounts, which continue to pay interest typically below 2 per cent.

Moreover, structured investment barriers of 50 per cent are significant; only twice in the past 20 years have we seen inter-year falls of that magnitude, both during financial crises.

However, as Tim Cockerill, investment director at advisory firm Rowan Dartington, observes, investors need to think carefully about the underlying benchmark and the current market cycle before deciding whether to invest in a structured product.

'If you are investing in a structured product that is linked to the FTSE 100, right now you might conclude that it is at a new high and question the upside from here, so a product offering some protection at this level might look interesting.

'If you had looked at the FTSE two years ago, however, you might have come to a different conclusion. Like any investment, it's a case of looking at what's on offer and putting that in the context of market valuation,' he says.

Cockerill argues that this is a particularly important point to consider when looking at auto-call products. If the market is roaring ahead and the plan matures within one or two years of starting, investors who want to put their money back into markets may well be doing so at the top of the market, increasing risk as well as investment cost.

The caps on growth plans may also prove detrimental in bull markets; for example, between 1 March 2009 and 1 March 2015 the average open-ended fund in the Investment Association's UK all companies sector returned 145 per cent, while most growth plans cap gains around 60 per cent.

BALANCED ARGUMENT

Regardless of market cycles, there are some who believe that a balanced portfolio of traditional assets provides all the protection an investor needs.

These include Patrick Connolly, financial adviser and head of communication at de Vere Group, who says his firm is currently not recommending structured products to any clients.

'Generally, we are wary about how structured products fit into client portfolios. For low-risk clients we've been focusing on balanced portfolios - a combination of equities, fixed income and property in the right proportions.

'It's about trying to get asset allocation right, rather than the one-size-fits-all structured product approach,' says Connolly.

Perhaps most important, however, is counterparty risk. With the exception of deposit plans, structured products are always at the mercy of the financial institution that they are linked to.

Some plans make use of more than one counterparty, while others link to the performance of other, typically FTSE 100, companies rather than banks (an arguably risker strategy).

However, as both Cockerill and Connolly observe, with skeletons continuing to be found in the back of banks' balance sheet closets, now may not be a good time for investors to be putting their faith in their continued success and survival through a structured product.


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