With interest rate rises on the horizon and ongoing market uncertainty investors face an uphill battle to find investment opportunities that can provide income or growth. However, structured products can offer better returns than investing directly in the market.
These are investments backed by a counterparty where the returns are defined by reference to an underlying measurement, such as the FTSE 100, and delivered at a defined date. They aim to provide some protection against market downside and achieve a defined outcome. Some products are growth orientated and some focus on income, and they typically have a maximum investment term of five or six years. So structured products can be used as a lower-risk way to get exposure to the market, without the volatility of funds or equities.
As with all investments, however, they involve downside risk. A structured capital-at-risk product, for example, might offer you 65 per cent on the investment if the FTSE 100 is at the same level or higher on the day the product matures in five years' time. If the FTSE 100 is below that level, it will return the investment capital - unless it is more than a specified amount below, say 50 per cent, in which case capital will be reduced by the equivalent fall in the FTSE 100.
Given current market volatility there is more risk of products falling below the level that is required for the product not to give you a return or reduce your capital. The type of barrier a product has is important. If it has an 'American barrier', if the index it is linked to falls, for example, more than 50 per cent during the term of the product, your capital will be reduced. But if it has a 'European barrier', then your capital is only reduced if the market it is linked to is down more than 50 per cent on the day the plan matures.
However, recent research by CompareStructuredProducts shows that no American barriers have been breached in the recent volatility, and with FTSE-100-linked products a 50 per cent six-year full-term American barrier observed at close of business each day was only ever breached during the three last days of the dot-com correction in March 2003.
And even with the ongoing market volatility, Alex Reid at financial adviser exhibit 3, says that with most products having a barrier of 40-50 per cent, and the FTSE 100's falls considerably less, a breach is unlikely. You typically get a better return with an American barrier, although Mr Reid says if you only get an extra 1 or 2 per cent it is probably not worth the risk. "If you want to sleep better at night go for the European barrier," he suggests.
Some advisers say now is a better time to enter structured products than when the market was higher, as it has potentially less to fall. "If you can take some downside risk on a structured product paying 6 to 7 per cent it could be a good portfolio addition in the current investment environment, and it is better to buy now than when the market was at around 7000," says Mr Reid.
But Jane Heyman, chartered financial planner at McCarthy Taylor, argues that market levels are still reasonably high with the FTSE 100 still above 6000, so there is more potential for it to fall than rise. She thinks when markets are lower it might be a better time to enter one of these products.
She also thinks investors may get mislead because structured products have done well recently as markets have been reasonably good - but people investing today might not do as well as those investing five or six years ago, when markets were lower and trended upwards. Five years ago the FTSE 100 was between 5500 and 6000, and after a dip in the second half of 2011 trended upwards until this summer.
However, Ian Lowes, founder of CompareStructuredProducts.com, says if you are anticipating severe market falls of 40 per cent or more then you should not be contemplating any form of equity investment.
How the products compare
|All products||Capital-at-risk||Capital protected|
|Number of products||87||47||15|
|Average total gain (%)||28.31||29.21||31.93|
|Average term (years)||4.1||3.43||5.24|
|All annualised return (%)||6.34||7.42||5.7|
|Top 25% average annualised return||9.3||9.99||7.87|
|Bottom 25% average annualised return||3.58||4.7||4.05|
|Top 25% average term||3.34||3.3||5.26|
|Bottom 25% average term||4.7||3.93||5.52|
Source: CompareStructuredProducts.com Third-quarter maturities for IFA-distributed structured products
Gainers v losers
|Number of maturities returning a gain||76|
|Number of maturities returning capital only||10|
|Number of maturities returning a loss||1|
Source: CompareStructuredProducts.com. Third-quarter maturities for all IFA-distributed structured products
If markets continue on a downward trend or do not rise much you will not do so well from a product that makes its returns according to a certain level of upside.
Even if the market doesn't fall so much that your capital is reduced, but rather preserved, you are still at risk from inflation over a five- or six-year period, although you would be in a better position than with an equity investment.
You get a predefined amount with structured products so if markets do very well your return could lag the market, whereas with a tracker, a fund or an investment trust your upside is not capped.
Structured products are typically structured as a loan to a financial institution, so you face counterparty risk with these products: if the institution becomes insolvent or for other reasons cannot honour its obligation you may not get your capital back. This happened to a number of structured products that had investment bank Lehman Brothers as the counterparty during the financial crisis.
However, this has not happened to any counterparty since then, and these are rated by agencies so you can have an idea of what the financial strength of the counterparty is. Credit ratings range from AAA for the strongest down to D for the weakest. You tend to get a better return with lower rated ones but Mr Reid says it is hard to tell how well priced in the extra risk is.
You can get details of counterparties and other information on the product providers' website or information sites such as CompareStructuredProducts.com.
Because structured investments have a set term if markets are not doing well you cannot sit on your investments and wait until they go back up to sell them, unlike with funds or investment trusts, where you can wait and choose when you exit.
Structured investments do not benefit from Financial Services Compensation Scheme (FSCS) protection unlike regulated unit trusts and open-ended investment companies (Oeics). If the latters' managers became insolvent you would qualify for up to £50,000 in compensation per company. However, structured deposits, fixed-term plans linked to the returns of an investment but where your capital is not at risk, are covered by the FSCS as bank deposits, so in the event of the deposit taker becoming insolvent investors can currently receive up to £85,000 per institution.
And unlike holding a share or a fund, structured investments do not pay dividends.
If you sell your structured product before its full term is complete you will not get any of the benefits of the intended outcome but rather just the value of the assets, which will depend on how they have performed. You may also have to pay an administration fee to do this. So you should not consider them if you are not confident you can hold them for the full term.
Structured investments have been accused of being opaque over charges because these are built into the product. Provider literature will typically set out a maximum range of what you will pay. But this can make it hard to compare products and you cannot know exactly what you are paying upfront.
However, charges usually very between 3 and 5 per cent over the full term of a five- to six-year product so are between 0.5 and 1 per cent a year, which works out slightly cheaper than the typical unit trust or open-ended investment company (Oeic) charge which tends to be between about 0.8 and 1 per cent. But for structured products with shorter periods this is not such good value.
Structured products are generally only available via advisers or platforms so you will also have to pay their fees. Platforms that offer structured products include www.moneyworld.com and CompareStructuredProducts.com, which also provides users with research and information on the products, but you may have to fill out an appropriateness form before you are allowed to invest.
Structured products have complicated structures so you should not invest unless you understand how they work, advises Colin Low, chartered financial planner at Kingsfleet Wealth.
To mitigate the risks of structured products you could hold a range of them with different counterparties. This would allow you to include some higher-paying products without overexposing yourself to risk, products with counterparties with lower credit ratings can give better returns. But advisers suggest that investors with a lower risk appetite stick to lower-risk products.
Mr Lowes also suggests not having products with all the maturities in the same year.
Structured products should only form a small part of a diversified portfolio, and it is very important you understand the risks. It also means that if markets experience a sharp rise, then some of your other investments can take full advantage of this.
Not all products are linked to an index such as the FTSE 100 - some link to a basket of maybe four or five stocks. Mr Reid cautions against using one of these products. "Although these are generally blue-chip names and you only lose if one goes down, say 50 per cent, the recent problems at Glencore (GLEN) and Volkswagen (Ger:VOW3) show that you cannot know where the next blow up will be. I don't expect the FTSE 100 to fall 50 per cent but one of these could, so I would always go for an index-linked product."
For example, HQX Two Year Fixed Rate Income Plan July 2013, which matured in the third quarter, paid a high level of income of 18.72 per cent but the maturity value was reduced by 22.92 per cent, resulting in a net loss of 4.2 per cent. This product, which had a low barrier of 20 per cent, combined a short investment term with capital linked to three stocks - BP (BP.), Vodafone (VOD) and HSBC - which had a low barrier of 20 per cent.
Current examples include Meteor 4 Year FTSE 4 Monthly Income Plan October 2015 linked to only four shares - Pearson (PSON), Aviva (AV.), IAG and Rio Tinto (RIO). You will lose money if the final level of the lowest-performing share is more than 50 per cent below its opening level on 25 October 2019.
Mr Reid prefers Meteor FTSE Quarterly Contingent Income Plan November 2015. This matures on 6 December 2021 and offers a potential gross income of 1.65 per cent a quarter or 6.6 per cent a year. If on any quarterly measurement date the closing level of the FTSE 100 is at least equal to 75 per cent of its opening level the plan will pay a gross income of 1.65 per cent for that quarter. No income will be payable for a quarter if on the measurement date the closing level of the index is below 75 per cent of its opening level.
You will lose some or all of your money if the final level of the FTSE 100 is below 60 per cent of its opening level. The plan will mature early if the closing level of the FTSE 100 on quarterly measurement dates (excluding the first seven) is at least 5 per cent above its opening level.
This plan is available until 11 November.
Mr Lowes suggests Reyker Securities FTSE 100 Supertracker Plan October 2015, which targets a growth payment of 10 times the percentage rise in the FTSE 100 capped at 80 per cent over six years. It has a 60 per cent European barrier measure so it has to fall 40 per cent or more on the maturity date for investors to lose capital.
The counterparty is Royal Bank of Canada, rated AA- by S&P, Aa3 by Moody's and AA by Fitch.
The offer closes on 15 October.
He also likes the Meteor Supertracker Deposit Plan October 2015, which offers a gross interest payment of 1.5 times the percentage rise in the FTSE 100, up to a maximum of 60 per cent. This is a fixed-term deposit that matures on 8 November 2021 and qualifies for FSCS protection.
If the final level of the FTSE 100 is above its opening level by up to 40 per cent, the plan will make a gross interest payment equal to 1.5 times the rise in this index. If the final level of the FTSE 100 is more than 40 per cent above its opening level, the plan will make a gross fixed interest payment of 30 per cent at maturity.
If the final level of the index is equal to or below its opening level no interest will be payable.
The counterparty is Royal Bank of Canada and the product is available until 21 October.
Ms Heyman says alternatives for investors wanting market exposure but less risk could include large-cap equity funds that pay generous dividends, or property funds that invest directly in property. You can see a number of suggestions for these in our IC Top 100 Funds, for example CF Woodford Equity Income (GB00BLRZQ737), City of London Investment Trust (CTY), and M&G Property Portfolio (GB00B8FYD926).
Ms Heyman also says to reduce risk you should maintain a diversified portfolio, and if you have a substantial amount to invest, drip feed it into the market over time rather than putting in one large lump sum.