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May 3, 2013 6:03 pm

Deconstructing the tangle of structured products for UK investors

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Controversial investments too complex, say critics
BEIJING, CHINA - FEBRUARY 28: (CHINA OUT) A man watches a screen as the Chinese stocks stabilized on February 28, 2007 as buying by local funds in financial blue chips pushed up the main Shanghai index, after the country's stock market suffered its steepest daily fall in the past decade, with the benchmark Shanghai Composite Index plunging nearly 9 percent to close at 2,771 on February 27, 2007.©Getty

Structured products sound like the answer to every investor’s prayers. An investment that pays out defined returns of 8 per cent a year at a time when interest rates are 0.5 per cent, without directly exposing your money to market risk – what could be better?

So why are critics of structured products so vociferous in their condemnation? Why did a Forbes magazine article refer to them as a “real stinker of a product”? And why is the head of the UK’s new financial regulator reported to have called them “spread bets on steroids”?

The answer is their perceived complexity.

In their simplest form, structured products are IOUs. Investors are offered the chance to make money based on the performance of an asset or collection of assets – say, the FTSE 100 – within predefined parameters and often with a measure of protection.

In exchange for set returns and possible capital protection investors forgo dividends, the full growth of the asset and the flexibility to sell out when they like.

Structured products began to appear in the UK retail market in the early 1990s, and by 2009 were estimated to have attracted £10bn of investor money.

But a series of catastrophes, including the collapse of providers Keydata and ARC Capital, have damaged the market’s reputation. Complaints are also up. Financial companies received 4,486 complaints about structured products in 2012, compared to 2,911 the previous year, according to the regulator.

The episode that industry insiders come back to most frequently is the default of Lehman Brothers in 2008, which left thousands of structured product investors exposed.

Providers insist that the market has simplified since. Risks are highlighted earlier, product terms are easier to understand and more sales are done through advisers.

Andrew Cooper, director of structured products at RBC Wealth Management, says there is no average when it comes to UK client investment in structured products, but that they all have a clear understanding of how the products work.

Who is buying?

The average structured product investor in Hong Kong is 42 years old, works in finance and has a monthly household income of HK$7,100, according to the international body of securities regulators, which published a global review of structured products in April.

In the UK, investors are likely to be either over 55 or under 35 and have three or more different types of savings products. In Slovenia they will typically buy structured products from insurance companies. In Australia they are more likely to purchase via advisers.

The consultation proposed a toolkit for regulators dealing with the sale of structured products and found that existing oversight of the product is varied.

In France, for example, issuers must submit marketing materials to regulators before distribution and in Belgium there was the suggestion of a total ban on sales of over-complex products to retail customers. In Germany the government has announced that it will look at structured products, but has no intention of banning them.

The UK’s new financial regulator, Martin Wheatley, chief executive of the Financial Conduct Authority, is reported to have told an audience at the London School of Economics that the regulator could use “nudges” to prevent complex investments reaching the wrong retail customers.

Now that the shake-up of the financial advice industry requires independent advisers to know about structured products, the market may receive an extra boost. But critics insist that the products are so complicated that neither investors, nor their advisers, have any real hope of understanding them.

For example, the Investec Deposit Growth Plan 24 is a five-year product that will pay up to 1.3 times the rise in the FTSE 100 – taking the average daily closing level between December 8 2017 to June 8 2018.

But how does Investec decide to offer 1.3 times the rise instead of, say, 1.2 or 1.4? In order to work out what rates they will pay out, issuers calculate the probability of the underlying asset rising or falling using statistical analysis. And this, say critics, is why retail investors will fall at the first hurdle. How can they compete with computer programs to work out these probabilities?

In “Why Do Investors Buy Structured Products ?” Thorsten Hens from the Norwegian School of Economics suggested that their popularity was more to do with investors fearing loss than competitive pricing and attractive offers.

Nev Godley of Morgan Stanley, who has 10 per cent of his personal portfolio invested in structured products, claims the charge of complexity is unfair.

“If you look at any product in serious depth then it will start to look complex,” he says. “Investors have to think about affordability and risk tolerance, but that’s true across any investment. If you are happy with the counterparty risk and the market risk then these are more straightforward than lots of other products. Plus they have predefined returns, so there is little scope for human error to miss targets.”

So what happens when you look at structured products in serious depth?

At any one time investors will find about 50 individual structured products on offer. The products can be divided into three main types: structured deposits, structured investments with capital protection and structured investments without capital protection.

These are all priced differently, taxed in different ways and pose different risks and rewards to the investor. Deposits are covered by the UK’s Financial Services Compensation Scheme, investments are generally not.

Structured investments will use the investor’s money to purchase a fixed income security issued by a counterparty – and confusingly, the counterparty can be the same organisation as the plan manager. Assessing the strength of the counterparty is essential and can be done by looking at credit ratings from agencies such as Standard & Poor’s and Moody’s.

Buying a security allows the issuer to pay back the money originally invested when the plan matures. The security in question may well be a zero-coupon bond, which is sold at a discount to its redemption value and provides the required amount at maturity, but no income along the way.

The remaining money is used to buy derivatives – such as call and put options – which give exposure to the underlying asset and provide the pay-off to investors.

The less capital protection offered in the structured product, and the higher the potential payout, the more money will be invested in derivatives – which give exposure to the performance of the asset (such as the FTSE 100) without buying the actual asset.

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For example, out of a £100 investment in a five-year structured product the provider might purchase a zero-coupon bond for £85, which will provide £100 in five years. They will then take £2 for administration and use the remaining £13 to buy a five-year FTSE 100 call (right to buy) option. The returns will depend on the option that can be purchased for that amount.

If the index rises over the term, the investor will receive the return on the call option – which is often leveraged – plus the proceeds of the bond. If it falls, the call option will expire worthless, but the investor will receive his or her money back. Put options, which confer the right to sell at a predetermined price, can be used to increase the potential return, but will add a degree of risk.

To go back to the £100 investment, if you sell a put option for £10 you have £23 to buy call options. But if the put option kicks in, then you may lose money.

Adrian Neave at Gilliat Financial Solutions says that while it is useful for investors to know the ins and outs of structured products they should also be clear, and reassured, about what is held in their name. “The client basically holds senior unsecured debt issued by the investment bank,” he says. “They are not holding derivatives or other forms of complex financial instrument.”


52% returns – if you can bear the risk

The main factors that determine how a structured product is priced are interest rates, the credit rating of the issuer and volatility in the underlying asset.

Structured products maturing now should have hit their targets because stock markets are up over three, five and six years.

But with markets now at or near record highs and interest rates low, prices are looking less attractive.

As a rough guide to returns, Lowes Financial Management, a financial adviser, says that a five-year structured deposit might pay out 27 per cent if the FTSE 100 is up at the maturity date.

A capital-protected structured investment might pay 35 per cent if the FTSE 100 rises over five years, and a capital at risk structured investment might pay 52 per cent if the market is up, but investors risk losing some of their capital if the market falls.

Gains from structured deposits are taxed as income and they can be included in cash Isas, while profits from structured investments incur capital gains tax. They can be held in stocks and shares Isas and in Sipps.

Providers say that in light of current markets they are seeing a boom in sales of defensive structured products, which offer a positive return even if markets fall, such as the Morgan Stanley FTSE Defensive Bonus Plan 10, which will pay 8.25 per cent each year from the second anniversary onwards for six years so long as the index does not fall more than 5 per cent.

Early redemption outside the terms of the investment may mean the returns are less than you invested There is a secondary market for products, but it remains small.


FOR: Structured products

Thonmas Hughes

While some structured products have undoubtedly produced returns that have disappointed investors, to criticise and dismiss the whole sector is potentially to miss out on some very interesting investments, writes Thomas Hughes.

Whenever we recommend an investment to a client, it is because we would be prepared to invest in it ourselves and often do. The structured products in my portfolio sit alongside a broadly diversified portfolio of unit trusts and other investments and in the main have helped to produce a very attractive overall return.

While many of my unit trusts have performed well, others have been rather lacklustre. But every structured product in my portfolio has done exactly what it said it would in the prevailing market circumstances. One of the most significant reasons we find structured products attractive is the defined nature of returns in defined market conditions, delivered at defined dates.

The latest addition to my portfolio is the Investec FTSE 100 Defined Returns Plan 3 which offers a 30 per cent gain after three years if the FTSE is above its initial level; or if not, a 50 per cent gain after five years if the FTSE is above its initial level. If it doesn’t mature on the third anniversary, the investment will only track a fall in the index at the end of five years if the index lost half of its value during the term. Counterparty risk is reduced through a collateralisation feature that utilises securities from five different banks, thus reducing the potential for catastrophic loss.

Thomas Hughes is operations manager at


AGAINST: Structured products

Alan Smith

For the right client, in the right circumstance, at the right time in the cycle, from the right “provider”, some structured products may be OK. But in the main, they are opaque and complex structures not suited to the retail investor, writes Alan Smith.

I have gone on record as saying that they are sold by lazy advisers who are able to use the behavioural and emotional appeal of an apparent “guarantee” to push them on to clients.

Do investors really understand the complex derivative instruments and pricing mechanisms underneath these products? For that matter, do the advisers who sell them?

Structured products are illiquid and can prove costly if you have to exit early. They are also highly inflexible – can any investor really say that they know what their finances and liquidity needs will be four or five years from now?

Many structured products track an index and exclude dividends, which makes a huge difference in outcome for investors. Giving up that income stream in exchange for some vague and uncertain guarantee doesn’t appear to be a great deal – especially as the “guarantee” is only as strong as those providing it.

A number of structured products are also based on a future index plus a geared percentage, over a fixed period. If there is a belief that the market will rise, why not just buy the index directly at low cost?

In reality there are very few five-year negative periods in the main stock indices – so in buying structured products, investors are paying a lot for protection against something that rarely happens.

Alan Smith is chief executive of wealth manager Capital Asset Management

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