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I first started writing critical articles about structured products in the early 1990s and warned of the possibility of the precipice bond disaster. Like many adviser firms, ours has very rarely recommended any specialist products in the past but, periodically, I revisit the SP ghetto to see what the geeks are up to just in case there are signs of intelligent life.

The problem with SPs from the outset has been the confusion of risk and probabilities. As is often the case, Warren Buffett has put it better than I can. “A small chance of distress or disgrace cannot be offset by a large chance of extra returns.”

Why? SP devotees will actuarialise you with statistics showing low probabilities of loss but this is not the important issue as far as the biggest group of possible investors are concerned, namely those with the highest aversion to risk. Here, the real issue is risk capacity, the individual’s ability to with-stand losses. This is not probabilistic – it is a matter of fact and of the adviser’s realistic interpretation of their circumstances and needs.

Take the classic little old lady with limited capital. If she buys a capital-at-risk product and it goes wrong, what are the consequences? What is the potential impact on her standard of living?

You cannot rely on the small probabilities of a loss-causing event based on the historical record. The credit crunch showed how wrong those probabilistic assessments can be. The point is that she cannot afford loss. It is therefore wrong to incur the possibility of loss, even if the prob-ability appears very small (probabilities in investment never “are”, they only appear and then change).

So I find it depressing that there has been a big revival in CAR products, which I fear are being sold by some IFAs (although they never seem keen to own up to this).

A second drawback that even the providers do not seem to understand is reinvestment risk. If you buy an income-generating SP, at the end of the term, you have to reinvest, with no idea what rate of return you will then be able to obtain. So the investor is exposed to a risk they have not thought about and would not really under-stand if they did. Try the thought experiment of a series of three five-year income-generating SPs compared with a 15-year investment in equity income funds. Providers will not be keen to show you the numbers.

So much for the old negatives. But the geeks have made improvements. Listing SPs so that they can be traded enables discretionary fund managers to churn these plans and generate even more commission. Kickout plans take to the extreme the play-the-odds gambles that could be sold at racecourses and appeal to the intuitive (and usually wrong) assessments of odds by naïve punters (doesn’t the bookie usually win?)

The only genuinely interesting development I have come across is the creation of SPs in the form of ongoing funds, such as those from SIP Nordic/ RBS, Privalto/BNP Paribas and Barclays. These provide an alternative form of absolute return investing that make an interesting comparison with, and may well complement, other absolute return funds. But this is grown-up investment, as opposed to SPs, which are what banks across Europe sell in huge quantities to their woolly customers.

Chris Gilchrist is director of Churchill Investments and editor of The IRS Report


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There are 6 comments at the moment, we would love to hear your opinion too.

  1. What planet is this person on? The idea of selling capital at risk products to people who cannot risk their capital is ludicrous. Have you heard of TCF?

    Sounds as though this so called advisor sells mutual funds to little old ladies, no risk of loss there then, and presumably you tell them there is no risk of dividends being cut?

    If you understood anything about structured products then you would also be aware that the level of charges in fund based products has a huge impact on the returns to clients compared to conventional issuance mechanisms. Mind you they do pay trail, whereas the conventional issuance programs do not. Does that influence your choice?

    Given your predilection for mutual funds perhaps the problem (apart from the obvious lack of understanding of structures) is that the fees on structures are so much lower than those involved in holding a retail mutual fund for five years, hence so are commissions.

  2. It’s a pity the first posting was anon as it does rather make Chris G’s point about advisers who use SPs posting anon and NOT standing by their comments. Anon has criticised Chris, but unlike Chris they have not had the balls to stand by their statements.
    I am neitehr for nor against SPs. There are products I will never use, but I’ve used income generating SPs often to try and get retired people to SPEND their money when their assets are unlikely to run out during their lifetime.
    Even before the FSA guidance on structured product usage I tried to treat them like an asset class (well they are really they’re just a bond, but with a bet attached) so that a client wouldn’t have all their eggs in the SP basket and tried to take account of both the indexes being tracked and the counterparty.
    As a result, despite the fact I have clients who have found SPs useful and some who have lost money (just as I have with mutual funds too), none have complained about the investment advice as the portfolio has not been catastrophically effected, whether it be for counterparty failure or for an index dropping too much.
    There is a place for SPs, but I do think they were over used as an easy “sell” without the donwsides as Chris describes them being kept in mind so that common sense could be applied when it came to the affect of a what could be more than a 50% loss on the value.
    Too often, common sense goes out the window, but no number of exams can make sure someone uses common sense.

  3. Oh Dear! The anonymous 1st poster is an embarrassingly good advert for RDR! Chris’s point is entirely right. SP’s are widely sold as low risk, when they are very high risk, but only occasionally. Those ‘mutual funds’ Anonymous derides include ETF’s and passive’s if charging is the issue, and though they can go down as well as up, the right way to achieve security for old ladies is to asset allocate across them, not to rely on an actuary and a derivatives salesman. The only guarantee in an SP is the manufacturer’s turn. All risk belongs to the old lady! That banks sell these at a far greater rate than IFAs is one of the things RDR will exacerbate, but if IFAs are as rude and wrong as Anonymous so often is, perhaps tour numbers should be thinned. If you can’t put your name to it you should not say it.

  4. Interesting article – suppose he should have started with ‘We are Independent Financial Advisers who specialise in collective investments’ (taken from Churchill Investments website – apologies for any copyright infringement!) to declare his starting position.

    Yet his company recommend funds that use derivatives for downside protection…..

    As i said, interesting article

    Personally I think that SP’s have a role to play, alongside Collectives and cash within a portfolio – but that’s just my personal opinion

  5. The Sunday Times Personal Finance Guide to Tax Free Savings:

    I was well aware of Christopher Gilchrist as a long standing and well respected financial author and broadcaster but wasn’t aware of his directorship of an IFA business – not sure how he has time to do that as well.

    I was drawn to this article through a bye-line which said that he was depressed by the increasing use of CAR and I thought, ‘why is Customer Agreed Remuneration depressing’? The dangers of acronims!

    The article and responses reveal the great schism which still runs straight down the middle of the UK adviser community – which is why MPs and others complain that there is no ‘one voice’ from the IFA industry. That schism is the difference between salesmen advisers looking for product to sell (the more ‘bells and whistles the better’) and service orientated advisers seeking investment portfolios to manage and the cheapest and purest method of accessing each ‘asset class’.

    Both can legitimately be called advisers but each has a very different business model and approach to what constitutes customer satisfaction. The former (e.g. Mr Anonymous, they normally are) simply don’t understand the latter and the latter (Mr Gilchrist and most of what are now called ‘New Model Advisers’) regard provider added complication (aka Structured Products) with complete suspicion and disdain.

    In fact, each can be appropriate but in different markets.

  6. The most common, though not universal, feature of SCARPS is that they provide an underwritten (and thus conditional) guarantee of returning at maturity the original capital, provided that the level of a particular stock market index (nowadays, usually the FTSE 100) at maturity has at no time fallen by more than 50% relative to its level at inception or, if it has done, then it has recovered fully.

    With this in mind, allied to a suitably strong counterparty, timing is critically important. 2003, when the FTSE was at a very low ebb (a bit below 3,400 I seem to recall), was a good time to consider SCARPS, because the upside potential of the index was very much greater than its downside potential. In other words, the risk of loss was minimal, because the likelihood of the FTSE falling over the then coming five years by more than 50% from 3,400 was, I suggest, pretty minuscule. UK plc really would be in big trouble if the FTSE 100 index fell below 1,700.

    By comparison, 2008, when the index had edged up past 6,000 on the back of a dangerously unsustainable boom in the UK economy, was a very unwise time to be recommending anything linked to the performance of the FTSE 100 index. With exactly the same product structure as outlined above, the risk of capital loss was of an entirely different order.

    And there are, these days, a number of SP’s backed by very strong counterparties (e.g. Barclays) that (conditionally) guarantee to return the capital at maturity irrespective of what the index does. They may not offer the potential for very exciting returns, but you pay your money and you take your choice. A good adviser will explain to his client these considerations in terms that most people of at least reasonable intelligence can understand.

    I have a client aged 77 (still a sharp old buzzard) who has sought my advice on options for reinvesting the proceeds of a With Profits Bond. It had performed acceptably well in its early days but had gradually gone the way of most With Profits investments over the past 10 years. He’s not unhappy, just looking for something different going forward from here.

    I provided him with summaries of all the SP’s currently approved by our network and discussed with him the positives and negatives of such products. He duly considered it all and then declared his preference for a portfolio of low to moderate risk unit trusts, notwithstanding that their values will of course undergo a measure of ebb and flow from time to time.

    That’s fine by me, because he’s made an informed choice ~ and not on the basis of risk but on the basis of flexibility and access.

    Chris’ article, though typically well written, appears completely to overlook all these considerations.

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