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The risks of structured products

Before you put your money in a structured product make sure you know the risks.

While structured products can be a useful investment vehicle in the right market conditions, these vehicles are not without their risks.

First off, it is important to realise that you could lose some or, in the worst case, all of your capital. Not all structured products come under Financial Services Compensation Scheme (FSCS) protection, - so make sure you check the exact compensation arrangements before investing.

For example, capital-at-risk structured products - these are packaged financial products typically based on a note (a fixed-term loan), derivatives or a warrant - are not deposit-based and as such are not protected by the FSCS.

In the case of structured deposits, which pay an income in the form of an interest payment linked to the performance of a given index or other underlying instrument, the original investment capital is guaranteed to be returned. Banks like to sell these types of structured products as a 'safe' way to participate in stock market returns without risk to capital. These products often provide capital protection by limiting the income payments generated by the product. Capital risk in this case is also replaced by counterparty risk, where the security of capital is dependent on the financial strength of the provider backing the product.

In the run-up to the 2007-09 financial crisis, a number of investors bought structured product plans from the now defunct companies NDF, Defined Returns Limited and Arc Capital & Income. The counterparty to some of these plans was Lehman Brothers, and when the bank collapsed in late 2008 many investors lost out on their structured investments and eventually all three providers went into administration.

The product literature attached to structured product plans can be complex and the structure of these plans is difficult to understand. Also remember that as these are fixed-term investments, you may face penalties if you withdraw from a plan before its term is finished. In some cases, early withdrawal is not permitted at all, making these plans relatively illiquid.