Lord Turner, the Financial Services Authority chairman who memorably described so much banking activity as "socially useless", has been tut-tutting about structured products. This catch-all term covers a whole range of products that use derivative strategies to produce defined outcomes for investors. I shall describe just one such product.
Gilliat Financial Solutions - part of Arbuthnot Latham - has just closed a new "Protected Kick Out" fund. Gilliat and its rivals offer these regularly. This one is based on the performance of five shares,
Basically, if all five shares perform well - or not too badly - you earn quite a handsome return, although not one remotely related to the actual return on the shares. You don't get any dividends. And you can't opt out once you're in (at any rate, the terms of doing so will constitute a very serious deterrent).
To get the maximum potential return of 50 per cent over five years, you're counting on any one of the shares falling by one penny or more in the first year. Thereafter, as long as at least one share is down by more than five per cent per annum from its starting price, your investment continues and you're on track for your 50 per cent. But you only want that to happen for four years, because the final settle-up - which comes after five years - depends on all the shares being no more than 20 per cent below their starting level five years earlier.
If, however, one share does lurch seriously in that fifth year, you get your money back but no return. I can assure you I have described Gilliat's "Protected Kick Out" in the simplest possible terms.
Is that a one-year investment or a five-year investment? It's really a one year investment with a catch. It's for investors who are bullish for the next year. But there's a sting in the tail if they're wrong. Because anyone whose one-year bullishness is unrequited is tied in for another four years and I dare any sensible person to have a structured view about the what is going to happen to these five shares between October 2012 and October 2016.
The appeal lies in the fact that you are more or less guaranteed not to lose your capital (assuming the
"Backtesting" statistics in the Gilliat prospectus observe that if you had taken out this investment on any trading day since 1998, you would have had a 32 per cent chance of being profitably kicked out on the first anniversary and a 73 per cent chance of being kicked out with a return by the fifth anniversary. But the covariances of these shares - how their prices move in relation to each other - are changing all the time, and the prospectus says nothing about that.
And in any case, I'm dubious about the message these statistics present. If you don't get kicked out with your return in year one or two, my feeling is that you are likley to be well off track - all or any of the shares will have lurched seriously and the prospect of getting back to that all-important baseline on a subsequent 31 October will be lower, not higher.
It's exceedingly difficult for the investor to evaluate what is truly being offered here. What this prospectus, and other structured product prospectuses, are missing is a symmetry diagram. The investor's return in all the possible scenarios is clear, but what is the bookmaker getting? If investors could see that, they'd understand structured products much better. I'm sure there must be a reason why they're not seeing it, and so, by the sounds of it, is Lord Turner.
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Alistair Blair, a past winner of the Business Writer of the Year Award, has worked in investment banking and fund management. Email: email@example.com