In recent months, the structured investment market seems to have been on the receiving end of a significant amount of criticism, with the FSA even suggesting that it will undertake a review of the sector and the way it is marketed. The FSA's comments seem to hint that, in some way, these products are not quite what they seem. Let us knock this suggestion on the head straight away.
There are basically two types of product:
Put-based. These have a predetermined maximum return which may be reduced if the option has to pay. A typical put-based product might offer a 9 per cent annual income but capital erosion if the FTSE 100 falls by more than a certain percentage.
Call-based. These have a predetermined minimum return but the call option may provide higher returns. A typical call-based product might offer the growth in the FTSE 100 up to a certain level but with the original capital protected. These will normally be growth products with no option to take an income.
In both cases, the option will be based on an underlying asset, a basket of shares or one or more stockmarket indices. However, most of the return comes not from the derivatives but from the investment of most of the subscription monies in fixed-rate notes issued specifically for the purpose of the product at prevailing money market rates.
The fundamental principle of structured products is that they give investors the opportunity of higher returns than a deposit account, with lower risk or at least a different risk profile than a direct equity investment. Structured investments are the only equity-based investments where IFAs and their clients can determine the bestand worst-case scenarios before making a decision as to whether or not to invest. The expression “it does exactly what it says on the tin” springs to mind.
Historically, it has been put-based products which have offered the best opportunities and dominated the market. Put-based plans can provide a high level of income without requiring any growth in the underlying asset and can even absorb a significant fall.
A figure of 10 per cent seems to be a psychological goal for investors. Wherever there have been products offering a choice of higher risk and higher returns (typically, 10 per cent) or lower risk and lower returns (8 per cent), the high-risk product has invariably sold better.
Over recent years, as interest rates have fallen, product providers have had to build in greater risk to products in order to achieve the magical figure of 10 per cent. Strategies have included increasing the number of assets measured, using more volatile assets or increasing the gearing of losses. Until 2001, products failing to make the full return were almost unheard of but the continuing bear market has changed this.
Five-year and six-year products maturing now were written when equity values were lower or similar to today and most will pay in full. Those written in 1998 and 1999 were based on higher opening values but also higher interest rates so. while some have produced lower than the designed returns, these have not been disastrous by any means.
Unfortunately, press comment has focused on the capital losses while ignoring the income or growth earned. This situation has been highlighted by one of our own plans, the three-year-plus plan, which was linked to the FTSE 100 and matured in April, showing a reduction of capital of 18 per cent. Yet it had guaranteed growth over the three-year term of 26 per cent, giving an overall return of 8 per cent. Over the same period, tracker funds actually lost between 15 and 20 per cent on a reinvestment basis.
Products issued in 2000 and 2001 (prior to September 11) were written against a background of high asset values and low interest rates. This inevitably has meant higher gearing of losses or more volatile underlying assets. With equities currently valued significantly lower than strike levels, there are potentially substantial losses to be crystallised. It is worth bearing in mind, however, that even these products offer protected income or growth, even if the capital is not protected. For example, a five-year plan offering 10 per cent a year will generate 50 per cent of the capital in income.
Products issued in 2002 will generally be more risk-averse than those of 2000 and 2001. Strike levels are obviously much lower and, against the background of potential losses in plans issued over the previous two years, less risky options and capital-secure options have often been tacked on to plans offering 10 per cent.
Yet higher income still appears to be a goal that investors are prepared to pay for by taking the higher risk. Also, there have been more call-based plans issued this year, offering undetermined growth but capital security.
Despite some very testing times for this market, the current economic climate offers an excellent opportunity for structured investment products. These products will provide investors with good levels of return in a market that may remain stagnant for some time, against a background of historically low deposit rates. Taking lower levels of return for higher levels of protection can offset the risks to capital and/or growth.
A key point to bear in mind when comparing these products with any other form of investment is that they are not high-interest bank accounts but equity-linked plans. However, in most cases, not all capital is at risk. It is also important when comparing structured investments with other forms of investment that the overall return needs to be taken into account rather than merely the situation regarding the initial capital.
Assessing the risk
These products are complex in their structure and providers should assist IFAs further to enable them to explain the products to their clients. Clearly, there is a limit to how simple the explanation can be. Nevertheless, it is essential for IFAs to have a clear perspective of each product and to know the worst that can happen, as well as under what circumstances they can be assured that their capital and investment return are secure.
The IFA has a responsibility to focus on each product individually and understand the differences and what implications these differences may have on the investment. Some products are more complex than others. Features to watch out for include:
Maximum and minimum overall returns.
Levels of protection – hard and soft.
Method of measurement – intra-day or close of business. This applies both to final measurement and to determine whether a breach has occurred.
Timing of measurement – closing levels. These can be an average or lowest level over a period or a selection of days or a single day
Timing of measurement of breaches – is it just the final one, two or three years or is it throughout the whole investment term?
The assets being measured. – index, indices or a basket of shares.
Gearing of losses.
Method of measurement
Intra-day measurement is always worse than close of business. Recently, the average difference between the intra-day low and close of the FTSE has been just under 1 per cent but it can be very significant and on several occasions the difference has been almost 6 per cent. This can make the difference between a breach or not and, where a product has breached, will make a difference to the final payment.
Generally, the more assets tracked, the higher the risk. For index-based products, the FTSE & S&P indices are considered to be the safest as they have historically been the least volatile. They are closely correlated so the risk on a product based on these two indices will be little more than a single-index product (but watch for the gearing).
Other popular indices include the Nikkei, Eurostoxx 50 and the Nasdaq. These are all more volatile, especially the Nasdaq. Individual shares will always be more volatile than an index.
Gearing of losses
Gearing is one of the trade-offs that providers have to incorporate in order to maintain the returns and provide the downside protection. Subsequently, all the time the underlying asset or index stays within the protection levels, nothing will affect the capital. However, if the protection levels are breached, losses will be compounded due to the downside gearing.
The majority of plans will have some form of gearing – 2 per cent for each 1 per cent is quite usual but it can be as high as over 4 per cent for each 1 per cent reduction in the underlying asset or index.
Last, we come back to communication. We have seen speculation as to how much investors might lose if stockmarkets remain at current or lower levels but these comments have ignored the income or growth element. In some cases, the products have in excess of two years to run so, without the aid of a crystal ball, no one can predict the final levels.
The key to any equity investment is investing at the right time. Structured investments give you more leeway with regard to timing but even they are not foolproof. An informed decision is the best that anyone can make, which is why education and good independent financial advice is imperative.