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Stay away from precipice

It may have escaped your notice that while sales of unit trusts have been sluggish, there is one area that is positively booming – structured products.

It is on course for a record-breaking year. Last year, they raked in £7.8bn, up by 14 per cent in 2006. This year, they are expected to attract £8.9bn according to structuredretailproducts. com, with 432 products already in 2008 compared with 721 all last year.

It should perhaps be of little surprise, given the nervousness that has embraced markets and it would seem that providers are lapping up every opportunity to entice investors with innovative products.

I am sure many investors will be tempted by the latest offering from James Hay – a plan linked to bombed-out banking shares with full capital protection.

Given that few want to call the bottom of the beleaguered sector, it might fit the bill for some. However, I wager that it will not go the full five-year term as it features early kickouts.

In other words, if all four shares are greater than the initial level after year one, investors receive a 13 per cent return and the plan redeems. If, after year two, all four shares are greater than the initial level, investors receive a 26 per cent return and the plan redeems – and so forth.

The commodity boom has also been a useful fillip to the sector – again suiting the risk adverse investor looking for exposure to a supposedly volatile arena. Some 59 commodity structured products – linked to a basket or individual commodities such as sugar, oil or metals platinum and gold have been launched since January 2007.

Yet many financial advisers are still sceptical about the plans and they have a point. They can be complicated to explain and they are not the panacea to market downturns.

For one, dividend income is excluded, while providers use several methods to calculate the final level of an index.

Many use so-called averaging, where the level of the index is averaged out over a given period such as six months or a year. If the index is averaged over a longer period, it should prove beneficial if the indices were to fall sharply in the final few weeks or days. The flipside is that investors will lose if the markets to which the bond is linked have climbed steadily but the final level is an average over the final 12 months.

Under this scenario, investors will on average effectively get four and a half years growth rather than the full five years.

Let us not forget that the credit crunch has also created uncertainty about the quality of the banks – think Northern Rock and Bear Stearns – underwriting the plans.

Keydata, a structured product provider, believes it has never been more important for financial advisers to read the label on structured products. No longer is an A-rated bank a dead cert for safety.

The nagging fear, however, is that the nastier products – akin to the infamous precipice bonds, which offered decent rates of incomewill start reappearing as providers look to offer sexier returns.

The move towards income-related plans is evident by the number of new launches in recent months. In 2005, there were just five income plans launched, in 2006, there were seven and last year 19, according to structuredretailproducts. com. Already this year, 31 income plans have been launched and there is still six months to go before the end of the year.

To be fair, providers have moved to bring out lowerrisk income products in the aftermath of the scandal that resulted in a number of fines being handed down by the FSA. Gearing levels of 2:1, which proved the downfall of precipice bonds, (now dubbed Scarps – structured capital-at-risk Products) are non-existent at the moment.

My concern is that providers often have short memories and I worry about how long it will be before protection barriers are relaxed – leaving mainstream investors vulnerable once again.

Paul Farrow is personal finance editor at the Telegraph Media GroupMoney Marketing

50 Poland Street, London W1F 7AX

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