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Riding the ups, but not the downs

Created:
17 September 2008
Written by:
David Stevenson

Structured products are changing fast. A new generation of providers is developing smarter funds that appeal to investors willing to do something different. Opportunities now exist for participation in everything from a basket of the key global markets through to an innovative product that invests in water firms as well as a note that gears up your returns from any bounce in banking stocks.

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Structured products have long appealed to cautious investors looking to balance participation in equity markets with an element of capital protection, or an above average income. The industry successfully recovered from the precipice bond fiasco and has now broadened its appeal via deals on the high street with the big building societies and banks.

But that high-street success has come at a cost - many investors are sold sub-standard products that offer risible participation rates in key stock markets. These guaranteed equity bonds - sold by a host of banks and building societies - play on that fear of stock market volatility by offering fairly rock-solid capital protection combined with participation rates on the upside of something like the FTSE that can vary from 70 per cent to 100 per cent (see The high cost of capital guarantees)

Take Nationwide, for example, which is marketing a Legal & General Capital Guaranteed Multi-Index Equity Bond 4. This six-year fund offers a minimum 12 per cent total return or 80 per cent participation in the upside of three major indices.

SPECIALIST PROVIDERS GIVE MORE UPSIDE

Newer and more innovative providers are offering products where the upside dwarfs this 80 per cent participation. Blue Sky, run by veterans from HSBC and Dawnay Day Quantum, is marketing a second version of its AAA asset allocation fund that offers upside participation in the FTSE 100, S&P 500, DJ Eurostoxx (Euroland) Index and the Japanese TOPIX that varies from 125 per cent (for the US index) through to 200 per cent (for Europe and Japan). But that participation is in addition to a core offer that will pay you out 10 times the first 6 per cent increase in these indexes up to a maximum return of 60 per cent at which point the participation rates mentioned earlier kick in.

To be fair to the Nationwide product, you get a guaranteed minimum of 112 per cent whereas the Blue Sky only guarantees to repay the initial investment (100 per cent), but the participation rates on offer from the Blue Sky product are hugely better than those on the Legal & General fund.

Barclays Stockbrokers also runs an innovative investment note programme that offers structured products which are listed on the stock market and can be traded in real time. One typical product in this range is the Accelerated FTSE 100 Return note that pays out a guaranteed return of 175 per cent even if the FTSE 100 trades sideways for the next five years - it also offers a regular income variation that will pay out 7 per cent income a year for five years and return your money in full. The risk is with what’s called a barrier, which means that if the underlying index is breached at a certain point - the FTSE 100 falls by more than 40 per cent from the initial level when the note was issued - your capital is at risk and the final payout is cut 1 per cent for every 1 per cent fall in the index.

Meteor is another new structured products specialist, has a flagship product called Prima Plus Plan 3 which will pay out a 15 per cent income (or coupon) annually as long as the underlying index (in this case the FTSE 100 and DJ Eurostoxx50) is above the opening/initial level. If the index has hit this point you get the coupon (taxed via capital gains), plus your money back, whereas if the index is below that level, your coupon is delayed until the next year when you could get a total of 30p in the pound. This 'autocallable', as it's called, rolls on for a total of 10 years in all and if the index has never hit the initial level you still get your initial investment back as long as those underlying indices have not fallen back by more than 50 per cent in which case you lose £1 for every £1 fall in the underlying index.

These auto-callables are hugely popular with higher-net-worth investors and coupon rates can vary hugely between 10p and 16p in the pound - Merrill Lynch has offered some with 18.2 per cent coupons – and investment periods that range from two to five years.

Keydata also offers some popular products in this space, especially around income. Their Defined Income Plan (Issue 4) offers an income of between 7.75 per cent and 8.25 per cent a year, but rather than track equity markets, invests the money in what are called Senior Life Insurance policies (via a bond). This innovative new market operates in the US and buys up lapsed life policies on business directors, keeps up the payments and then takes the cash when the policy holder dies. This fast growing and niche market is far from being mainstream but it does generate a steady income. Keydata also offers a more conventional Capital Protected Growth Plan that is a straightforward FTSE 100 tracker vehicle with 100 per cent capital protection (and no barrier) alongside a passable 109.5 per cent upside participation.

The bottom line? If you’re looking to buy a product that balances great upside participation rates or an income with some form of capital protection, you’re much better off going to this new band of innovative providers.

EXOTIC CHOICES AT THE HIGH END

Some of the most interesting and exotic structured products come at the top end (aimed at wealthier and more sophisticated investors) from the derivative products departments of the big investment banks Société Générale and Barclays Capital.

SocGen’s structured products range, developed by their covered warrants and exchange-traded funds (ETF) teams, is easily traded on the market in real time. In particular their structured listed note programme is varied and hugely popular. It features a daunting array of vehicles that access everything from European property through to bear certificates which make you money even if key global markets keep on falling (SN01 and SN03).

One of the newest vehicles is their SLS Emerging Index Protector - each certificate costs £1,000 with a ticker SG66 - which buys into an SG Index that tracks some of the world's leading emerging markets. It’s not a widely traded index but it does offer access to big markets like Brazil and Turkey and the certificate pays out a fairly juicy 230 per cent upside with a minimum payout of £700 per certificate regardless of any barrier. These listed structured products can be easily purchased via any discount broker on line and are traded in real time.

BarCap has long been a pioneer in the field of structured products although their funds are more difficult to access via cheaper online stockbrokers - you’ll probably either need a financial planner or an advisory broker service although clients of Barclays Stockbrokers can also access their products easily. Some of their newest funds - all boasting secondary listing on the market - include a five-year autocallable (they actually call it a split) that offers a 10.1 per cent payout based on a basket of banking shares plus a three year note that offers 180 per cent upside on a basket of big banks (Blue Sky has offered similar products in the past).

This last product is typical of a new idea in the structured products sector - take a basket of shares rather than an index and then offer investors upside participation in their fortunes. The BarCap fund is equally weighted between HSBC, HBOS, Standard Chartered, RBS and Lloyds TSB (Barclays are obviously not on the list) but there’s no capital protection on the downside, so if these shares carry on falling, your money is at risk.

BarCap has also been active in emerging markets and commodities, but one of their most compelling products recently has come in foreign exchange. Their Celsius GEMS fund offers a basket of high-interest-rate emerging-markets currencies (15 in all) in one sterling fund - in effect it's what the market calls an emerging markets carry trade in that lower-yielding currencies such as sterling and dollars are sold to buy high-yielding currencies.

Merrill Lynch also offers a range of structured products, again sold mainly to higher-net-worth individuals and brokers, but accessible via some mainstream brokers. They’re increasingly specialising in autocallables - on the FTSE and the Euroland DJ Eurostoxx market - with a huge range of coupons and maturity dates. Investors can access information on this ever expanding product range via their two web sites at www.definedfunds.ml.com and www.londonlisted.ml.com.

COMMODITY PRODUCTS

If you abandon the big high-street providers you also open up your opportunities to access innovative new asset classes. Quantum has excelled at offering structured product funds that give investors access to commodities and emerging markets, but its latest product targets the global water industry. It tracks the S&P Global Water index (this is also tracked by an iShares ETF) and offers 100 per cent participation in the upside of a basket of the world's leading water equipment and supply specialists plus full 100 per cent capital protection with no barriers.

Quantum's commodity funds - none available at the moment - are also interesting in that they pioneered a structure offering full capital protection, plus participation in a basket of commodity spot prices with upside participation that varied between 160 per cent and 210 per cent. Investors can still access this same concept via listed structured investment trusts offered by BNP Paribas and Close FM with participation rates in similar commodity baskets that range between 200 and 360 per cent.

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