Last week's news that structured product provider, Keydata Investment Services had been placed into administration, sent out a few shockwaves - and not only to the 80,000-plus investors who had put their money into the company's plans. Structured products appeal to investors at times of uncertainty - offering participation in the upside if markets take off, and protection from the downside if they bomb. There have been a plethora of new product launches and sales have surged, with investors, independent financial advisers (IFAs) and even fund managers seeking them out.
While there are still some serious questions around the transparency, and security of these products, some believe there is an argument to be made for the role of structured products in delivering efficient, risk-adjusted returns. So should you be considering structured products?
A tainted history
Sold by both high street banks and investment firms, structured products are essentially pre-packaged investment plans which deal in derivatives. They offer investors a predetermined return profile based on specific circumstances related to an index or underlying assets.
As promise of a market turnaround beckons, a gush of new products are being launched in the structured product space, and nervous investors are climbing in. Others, however, remain sceptic, given these investment vehicles' tainted past.
"In the early noughties, structured products failed because the markets fell way beyond expectations. Big name brokers who sold masses of these products - then called 'precipice bonds' - went out of business as the compensation claims mounted," says Danny Cox, chartered financial planner at Hargreaves Lansdown.
But you don't have to go that far back to witness how structured products have let down investors . In 2008 the beleaguered Lehman Brothers was the counterparty backing a number of structured products issued by companies such as NDF, Meteor, DRL, Arc and L&G.
While the Financial Services Compensation Scheme (FSCS) will step in when investors lose money as a result of the investment firm going bust (the limit for investment claims being £48,000, rather than £50,000 for bank savings), this does not apply to the counterparty. So if the plan manager of a structured product, like Keydata, goes into administration, the FSCS could step in. However, if it's the counterparty backing the plan that goes bust, things become more murky.
Bottom line? Investors who put money into structured products backed by Lehman Brothers are still in limbo, and may not receive their capital back.
While the collapse of Lehman Brothers has brought the issue of counterparty risk to the fore, the Investment Management Association (IMA), which represents the UK fund managment industry, has for some time been at loggerheads with structured product providers over the transparency of their plans, saying that the disclosure requirements for products which compete in the same market as funds needs to be similar.
Richard Saunders, chief executive of the IMA, believes that while the last few years have born witness to notable volatility in the stock market, risk is still capable of being managed through diversification, both over asset classes and over time. "Funds are not perfect. But they can be used to manage risk, and at least they are transparent - what you see is what you get. In turbulent times that remains worth holding onto."
Earlier this year, Mr Saunders welcomed a Financial Services Authority consultation paper proposing a new framework to regulate the way that banks treat their customers, but raised concerns that the draft rules do not consider more complex products such as structured products, of which the banks are major providers.
"These products are marketed as equivalent to investment funds - hence there should be a level playing field both from a consumer protection and a competition viewpoint," says Mr Saunders. "What's more, these products are actively marketed by banks as offering many of the benefits of investment products but with limited down-sides. But in terms of security, they are no more secure than any other bank deposit, and some being marketed by major retail banks in the UK are in fact deposited with their offshore subsidiaries."
Other issues
As the IMA continues its battle for greater disclosure around the configuration of structured products, there are a number of other concerns surrounding these plans.
"Structured products are not only complicated – they are inflexible and generally investors are disappointed with the returns," says Mr Cox. "The product literature is often confusing and investors are lured in with high headline rates of return, often not understanding the risks."
Others argue that post-Lehmans, the structured product environment has undergone a massive overhaul, with most providers now identifying the counterparty.
But Mr Cox is not convinced. "Even after improvements in terms of risk warnings and literature, understanding the structure, risks and who the counterparties are is difficult - even for the trained eye," he says.
Nick Fletcher, chief executive of fee-based IFA, Saunderson House, says that while superficially attractive, structured products fall down on a number of counts other than counterparty risk. "One - they are illiquid, requiring the investor to lock away their money often for several years with limited opportunity to realise their investment until maturity. Secondly, they are opaque: it is not clear how much of an investor's subscription goes into the guarantee, the option that delivers the return, or into the charges."
A further issue, which Mr Fletcher raises, is that many structured products usually only pay a return based on the capital value of the index to which they are linked. He explains: "Often no income is paid out or accrued within the product. So, for example with an historic yield on the FTSE 100 Index of 4.68 per cent an investor is forgoing a meaningful dividend payout that, compounded over the life of the product, would significantly increase the overall return."
| CASE STUDY |
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| In 2003, internet bank Egg marketed a structured product based on the FTSE100. It offered 100 per cent capital protection, plus 100 per cent of any upside between the value of the FTSE100 at the opening date (around 4,169), and a closing value defined as the average of the FTSE100 between July 2008 and July 2009. The product generated no income and no redemptions were allowed. At the time of writing, the closing value would have been 4427.02 - giving a gain of just 6 per cent over six years. By contrast, the FTSE100 itself would have returned 7 per cent over the same period, and considerably more with dividends reinvested. Even money left on deposit in an Egg savings account over the same time-frame would have produced a better return than the structured product. |
The case for structured products
Despite the many criticisms of structured products, vast volumes of these policies are still sold, with sales in 2009 estimated to reach the £10bn mark.
Colin Dickie, a director at structured product provider, Barclays Wealth, expects IFAs to up their usage of structured products in 2009, commenting that ongoing market uncertainty is acting as a key driver as advisers seek ways to improve clients' potential returns in a worsening environment for savers.
Fund managers' use of structured products in investment portfolios has also grown in popularity with a number of retail funds holding significant percentages in these plans.
Clive Moore, managing director of IDaD, a specialist structured product consultancy, says this is nothing new. "Funds have been making investments into structured products for years and this is on the increase. Professional investors are really benefiting from using structured products in their portfolios and the smarter ones are delivering much better performance as a result." He points to the Premier Absolute Growth Fund, run by Paul Branigan as an example.
Mr Moore says the capital protection and exposure to equity growth available in structured products delivers the most efficient, risk-adjusted returns. He cites research into the use of structured products by the Edhec research centre in France, which suggests efficient portfolio management techniques should lead to holdings of up to 80 per cent in structured products within bond and equity portfolios.
Does what it says on the tin
There are more reasons why Mr Moore advocates structured products. He argues that with the odd exception, these products are easy for investors to understand and deliver clearly defined returns. "They are normally excellent value - typical charges amount to a total of 5 per cent on a five-year product. Investors and advisers can choose a level of capital protection to suit their circumstances and they know exactly what a market outcome will mean for their investment returns."
Mr Moore adds that these products offer a range of tax efficient structures to choose from – for example, investors can choose a growth investment and avoid income tax, which can be especially advantageous given the increased tax rate for high earners. Capital gains on a growth investment will be taxed at only 18 per cent, rather than a 50 per cent top rate of income tax.
He continues: "Compare structured products to other income investments. Someone with £10,000 investing in a structured income product that pays 7 per cent income per annum would receive income payments of £700 per year, with a clearly defined return of capital after five years.
"The same investor choosing a corporate bond fund with a 7 per cent yield would immediately have £500 taken off due to upfront charges, which are usually around 5 per cent. The yield would drop to around 6 per cent after the annual charges, leaving the investor with a significantly lower income of £570 per annum. Also, the income and capital values would fluctuate considerably with falls in the index." [Editor's note: investors who buy a corporate bond fund through a fund supermarket will usually get a hefty discount on the initial charge].
Despite a lot of structured products being sold via IFAs, Mr Moore believes it is unlikely that commission fees are driving some IFAs' love of structured products, saying that for tied financial advisers, these vehicles are nowhere near as profitable as sales of mutual funds.
Mr Moore makes some compelling arguements, but what about the big C – counterparty risk? He claims that most structured product literature makes it clear that if the counterparty defaults, the investor will not be protected by the FSCS.
Consequently, investors and advisers should always pay attention to the counterparty. That said, Mr Moore points out that one of the most popular providers of structured products in the UK at the moment is Investec, domiciled in South Africa and with a BBB credit rating - one notch above sub-investment grade. "So either IFAs are wilfully ignorant or very relaxed about the state of the global economy. Or maybe it's the age old story of a good brand clouding investors' and advisers' judgement, as was the case with Equitable Life and some of the high street banks," he adds.
