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Investing can be risky, so the emergence of structured investment products has offered cautious investors a lower-risk option, allowing you to sleep at night, knowing your initial capital is protected.
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Anyone who invested near the peak of the 1999-2000 technology, media and telecommunications bubble, only to see their equity holdings halve in value during the subsequent three-year bear market, will be all too aware that the standard small-print warning "investments can fall, as well as rise, in value" should be taken seriously. Now, though, there are a wide variety of structured products on offer to investors who are unwilling to run the risk of seeing their investments nosedive.
And while conventional investments are long-only, dependent on the growth in value of shares, funds or other assets - so if prices fall, you're scuppered - structured products allow you to take exposure to the growth of a market without any risk to your initial investment. They can even be used to profit from price falls (known as going short).
The role of structured products in a portfolioThis could now prove useful. Since the FTSE All-Share index hit its recent nadir on 10 March 2003, the UK market has risen by a whopping 94 per cent. However, many investors have become nervous, fearing that the recovery could be overdone, especially in the face of rising interest rates.
Star fund managers, such as Anthony Bolton (of Fidelity Special Situations) and Nigel Thomas (of Axa Framlington UK Select Opportunities), are warning of an impending market correction, which could be much steeper than the temporary reversal that shook markets last May. Private investors are worried about the direction of stock markets, too, as demonstrated by the fact that the top-selling fund category last year was commercial property, not equities. Barclays Stockbrokers also reports that a record number of clients have set stop orders against their holdings (stop orders can trigger a sale, if a share's price falls to a predetermined level).
If you share their concerns about a stock-market fall, but would still like exposure to equities in the hope that they could keep rising, then it's time you considered a structured product. For example, you could take advantage of the fact that capital gains tax (CGT) does not apply to individual savings accounts (Isas) and personal equity plans (Peps) by selling shares or funds held in them and switching into low-risk structured products. It would also be possible to do this tax-free within a self-invested personal pension (Sipp) and it could be an appealing strategy, if you are approaching the point of drawing your pension and do not want to run the risk of a stock-market crash in your final years of investment.
Structured products could equally appeal if you would like to park some cash for a period, seeking capital preservation primarily, but hoping for some stock-market gains, too. Of course, there are disadvantages. A structured product, unlike cash, will not earn you interest, as well as preserving your capital. Nor will a structured product pay you equity dividends, which can be an important part of the return from equities, especially in a flat market. Another disadvantage is that many products require you to lock your cash up for a fixed term of, say, five years - however, shorter terms are available and an increasing number of structured products can be traded daily.
But structured products can still play an important part in a diversified portfolio, giving exposure to certain markets or asset classes. In fact, many structured products offer an attractive combination of enhanced exposure to specialised indices, with complete downside protection. Where products are tradeable, you could therefore enjoy enhanced upside and then sell out, taking profits before maturity.
Although the vast majority of structured products offer exposure to the FTSE 100, you can also take exposure to a range of underlying assets, such as foreign stock markets, commodities, house prices, hedge funds and fund portfolios. You can also use structured products to generate an income - with a degree of capital risk - or to go short of stock markets, benefiting from any fall, or getting your money back.
For example, structured products can be particularly attractive for investing in commodities, not only because you benefit from enhanced exposure, but also because commodity prices can be very volatile. Similarly, given that the Japanese market has a very low dividend yield and a high degree of volatility, an active fund manager may struggle to outperform structured products exposed to Japan.
There are three main types of structured product:
Click here to download tables of all the structured products currently available (as a PDF file)
Retail productsRetail structured products tend to be simple and easy to access but they are prone to drawbacks and may not offer good value.
The basic structured product model is to invest most of the initial capital in fixed-rate cash bonds, guaranteeing the return of your initial investment at the end of a fixed term. The remainder is then invested in call options, which either make enhanced gains if stock markets rise, or expire worthless.
The amount of exposure a product offers depends on three factors: the price of options, the rate of interest available on the cash, and the level of charges taken by the provider. High charges, including marketing costs and commission payments to IFAs, can mean that retail products do not offer good value. While some retail products offer enhanced exposure to an index (130 per cent of any rise, say), others will limit participation (to 70 per cent of any index rise, for example) or set a maximum upside.
Retail products must be held for a fixed term and capital protection will only apply if you hold to maturity. So the initial investment might not be returned in full, if you have to sell early unexpectedly or if your estate was wound up prior to a product's maturity.
Some products may only offer limited capital protection, in order to provide enhanced upside exposure. And products offering income do so by selling put options, which could trigger losses if stock markets fell below a predetermined value.
As a result, many investors suffered losses on early, high-income structured products, known as precipice bonds, during the post-2000 bear market when safety levels proved inadequate. Income products like these have now reappeared, but they should be safer than the first wave, as the income levels are more realistic and safety levels tend to protect against market crashes of up to 50 per cent. The earlier models were often in trouble after 20 per cent falls and losses were sometimes enhanced (on a three-for-one basis, in some cases).
Full, or 100 per cent, capital protection, is known as hard protection, while partial protection is called soft protection.
But apart from the participation rate, the level of protection and the lifespan, you should also look out for any unusual features. Some 'kick-out' products redeem early, if the underlying index passes a certain level after a time - for instance, a return of more than 30 per cent by the end of the third year could trigger a 30 per cent return. Other 'lock-in' products preserve gains at a certain point, but you then have to wait for maturity to get your profit and initial capital back.
Look out, too, for products giving exposure to several indices, which could make calculating returns difficult. With all products, the final index return could be based on the value on maturity, or on an average reading over the last months - or even the last year - of a product's life.
It is also worth checking the tax position, if you are not investing through an Isa or a Sipp. Some products are subject to CGT, allowing you to take advantage of the annual exempt allowance, which is currently £8,800. Others are subject to income tax and so might be less tax-efficient, especially for higher-rate taxpayers.
For more information on retail-structured products, ask an IFA about current and forthcoming offers. Most offers require minimum investments, which can be as high as £5,000.
SyntheticsSynthetics can offer many advantages over retail products, but they are more complicated, and can be hard to research independently.
IFAs who work for commission rather than fees will ignore synthetics, as no commission is available. It can also be hard to find information on synthetics, although your broker should provide you with current data (and information can be found at www.definedfunds.ml.com). The plus side is that the lack of commission and marketing costs allow synthetics to offer higher levels of exposure than retail products.
A complicating factor is that synthetics can be traded on a daily basis. On the one hand, this is a major advantage over retail products, allowing you to buy in or get out at any time, provided a seller or buyer is available (although liquidity can be patchy).
On the other hand, secondary buyers will not get the returns from the start of the term but rather during the life of the product, where the initial share price could be well above its opening level, but below the trust's current value (which cannot be accessed until maturity).
Equally, capital protection only applies to the initial share price and not to the price a secondary buyer pays. So you could hold to maturity and suffer a capital loss, even though you would receive the initial price back. What's more, not all synthetics offer hard protection of the initial share price - some only offer soft protection, so losses could be enhanced.
Potential returns may be capped, in which case the maximum possible gain from the current price will be shown by the redemption yield. The current price normally trades at a discount to the redemption value, reflecting the remaining time to maturity.
You can currently use synthetics to take exposure to UK, US, European, Far Eastern and Japanese indices, as well as commodity portfolios. There are income synthetics, too, not to mention Merrill Lynch FTSE 100 Reverse growth (which lets you go short), BNP FTSE Summit (which lets you capture the FTSE's peak) and Enhanced Global Asset Allocation (which weights your return on maturity to the best-performing of four markets). Synthetics can be held in Isas and Sipps.
Investment notesBarclays' new investment notes are very similar to synthetics but are intended to be accessible to a non-specialist audience - and if they are popular, more providers could enter the market, increasing the range of products.
Like synthetics, there is an initial offer period (only open to Barclays customers) and then the notes are tradeable on a daily basis until they reach maturity (when capital protection applies). Barclays acts as market maker, guaranteeing liquidity (more notes can be issued at any time to satisfy demand), and current prices and underlying values are readily available at www.stockbrokers.barclays.co.uk. You can buy them on the secondary market through any broker and they can be held inside Isas and Sipps.
So far there are six notes, offering a range of upside/downside profiles and lifespans: Energy-linked (100 per cent upside [from exposure to oil and gas prices], 100 per cent capital protection, six-year term); Nikkei225 (200,100, six); FTSE 100 (130, 100, six); Global Accelerator (230, 80, six); EuroStoxx50 (150, 100, six) and China (125, 100 - unless the index falls over 40 per cent, five).
Offer periods have just begun for two new notes, which track portfolios of companies in specific industrial sectors: Alternative Energy (100, 100, five) and Global Infrastructure (140, 100, five). The minimum investment is £500 each and the offer closes on 22 February.
AlternativesListed CFDs offer enhanced upside exposure plus capital protection as they allow you to set stop orders in case the market falls to a predetermined level. You do not have to top up your margin, unlike with conventional CFDs, plus all funding costs are included in the price. For more information, see www.listedcfds.com.
Protected funds, such as Close's escalator range, are similar to structured products, but are open-ended. They aim for capital preservation (normally on a quarterly basis) with some upside, limited by the cost of options.
Click here to download tables of all the structured products currently available (as a PDF file)
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-IC-1.5.4a-prod - 31/10/2008 13:11:34 - carlos.princz
