Sales of structured products typically boom when markets are full of uncertainty. They advertise a 'have your cake and eat it' scenario of exposure to the upside, but an element of capital protection on the downside. However, they've also attracted some vociferous criticism.
Structured products are widely marketed by high-street banks and insurers. They are fixed-term investment plans related to the returns on an index or asset which attempt to limit downside risk. They can enhance returns that might not be achievable by direct investments in equities or funds - for example, in sideways trading or falling markets.
Capital-at-risk products aim to protect your original capital sum, while giving you some additional upside. The Legal & General FTSE Growth Plan 7 is a good example; it offers investors the potential for a 50 per cent gain at maturity, provided that the FTSE 100 index closes on 6 January 2016 at, or above, the initial index level. If the final index level is below the initial index level no gain will be achieved but investors' original capital should still be returned in full. But if the final index level is 50 per cent or more below the initial level the original capital will be reduced by the percentage that it is below the initial level.
"Kick-out" plans mature early, maybe after two or three years, if the index to which they are referenced has risen a certain level above its starting point by that time. The Morgan Stanley FTSE Kick Out Growth Plan 7 aims to return investors' original capital in full after six years, in addition to growth equivalent to 1.3 times any rise in the FTSE 100, with no upper limit on the potential gain. The plan can also mature early after three years if the index is at least 10 per cent above its initial level, in which case it will return the original capital in full plus a 50 per cent gain.
If the final index level is below the initial level, no growth will be achieved but the original capital should still be returned. But if the final level is 50 per cent or more below the initial level, the original capital will be reduced by the percentage fall in the FTSE 100.
Risks
The main risk with a structured product is the counterparty because your return relies on this entity, usually a bank. Structured products aren't trackers; although your returns are related to an index such as the FTSE 100, your investment plan does not actually buy the shares. Typically, the plan provider splits your money into two parts, with most of it buying a corporate bond from the counterparty. This collateral funds the repayment of all or part of your initial investment when the fixed term ends. The rest of your money is invested by the counterparty in derivatives to produce either income or growth, as promised by the plan.
If the counterparty gets into financial difficulty, you could lose some or all of your investment. During the financial crisis, for example, some investors lost out on their structured products when US investment bank Lehman Brothers became insolvent.
The counterparty for the Legal & General FTSE Growth Plan 7 is HSBC, which has a AA rating. Morgan Stanley, which has a single-A credit rating, is the counterparty for the Kick-out growth plan referred to above.
Limitations
Aside from counterparty risk, structured products have other limitations:
■ Upside may be limited, with returns capped at a certain level even if the stock market rises higher than this.
■ Structured products do not benefit from share dividends, unlike shares which a fund holds directly.
■ You may face penalties if you withdraw from your product before its term is finished, or early withdrawal may simply not be permitted. This makes structured products relatively inflexible and unsuitable for those with higher risk appetite who want full control;
However, structured products do have some advantages. There are very few other products which can offer both upside leverage and downside capital protection. The Gilliat UK Growth Multiplier, for instance, gives you eight times any rise in the FTSE 100, capped at 80 per cent, allowing for a significant amount of market upside. If the final index level is below the initial level, no growth will be achieved but the original capital should be returned in full. Only if the FTSE 100 more than halves at any point during the term is the original capital eroded (reduced by 1 per cent for every 1 per cent the final level is below the initial level). The counterparty is Royal Bank of Scotland, which has a A+ rating and is majority-owned by the state.
Structured products can also provide exposure to more esoteric assets such as commodities or emerging markets, which could be useful for investors who are concerned about the volatility of these areas but would like to tap into what look like promising returns. Examples include the Gilliat Precious Metals Kick Out which features the potential to mature on any of the plan's anniversary dates from year two onwards, providing that gold, silver and platinum close at or above their corresponding initial prices. The original capital investment plus a 15.5 per cent gain for each year the plan has been in force are returned.
If the final price of one or more of the commodities is below its corresponding initial price, no growth will be achieved but the original capital should be returned. If the closing price of one or more of the commodities is more than 50 per cent below its corresponding initial price at the end there will be a reduction to their original capital investment of 1 per cent for every 1 per cent the final price of the worst-performing commodity is below its initial price.
Morgan Stanley is the counterparty for these products.
Barriers
An important feature to watch with a capital-at-risk product is the type of barrier it uses. The barrier refers to the level that the reference index has to fall beneath for you to start losing your original sum of money.
With a 'European barrier', it's the closing level that's the decider. If the index is above the barrier at the end of the term, you get your money back, even if it has dipped beneath the barrier at other points during the term.
The 'American barrier' is more risky: if the index on which your products returns are based falls below the barrier at any time during the term of your product, then you may lose some capital, even if the index has recovered by the end of the term.
