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Structures for defined returns

We are in uncertain times. Equity markets are volatile and interest rates are falling, so where should nervous investors turn?

Completely risk-averse investors will not be keen to commit any money to the stockmarkets and will look towards holding cash or gilts. These are, of course, very safe investments but offer fairly unexciting performance in return. But for those investors prepared to take some risk, structured products may be an attractive home for part of their portfolio.

It is probably worth explaining what I mean by structured products. Essentially, I would consider a structured product to be any product that uses derivatives to offer some form of predefined returns. A huge variety of products is possible but the market can be divided into two main types – income and growth products. These have very different risk and return characteristics.

Set out below is a brief summary of the key elements of each main type and some of the things worth looking out for when deciding the suitability of a product.

Income products

These offer a defined rate of income over the life of the product or rolled up and returned at maturity. An investor&#39s original capital is also returned at maturity given that certain performance criteria have been met, for example, a specified index is not more than 20 per cent below its initial level at the end of the product term.

There are a lot of these products being promoted with income yields of between 7.5 and 11 per cent. But it is worth noting that there is no free ride in terms of yields on these products. Higher yields can only be generated by running higher risks. These risks need to be understood before a sensible conclusion can be reached on the appropriateness of a product for a particular investor.

When looking at income products, features to focus on include:

Product term – products on offer have terms of between one and five years. Predominant, however, is the three-year term. This preference has frequently been explained to me as a reflection of investor reluctance to commit for longer periods. That said, products with lives of three years have – rightly in my opinion – attracted criticism given that the underlying risk is linked to equity markets. Intermediaries are quite used to advising investors that equities should be bought with at least a five-year time horizon. I would advocate that the same philosophy is needed with these kinds of products.

Downside risk – the trigger for capital losses will vary. Many products are at risk if there are falls in the underlying investments at any stage over the life of the product. This increases the risk considerably compared with a product which is simply looking at the change on a start-to-finish basis. It is probably fair to say that a lot of investors will buy these products with rather more focus on the yield than with any expectation that they will suffer a loss.

Until recently, the prospect of an index falling over three years would be considered small, so the large downside gearing (up to 6:1 with some products) would not be viewed as much of an issue. Recent events should give investors a wake-up call that index falls over a number of years are more of a possibility than they had originally thought.

A recent FSA press release warning consumers on the risks associated with high-income products should encourage IFAs to take this matter seriously.

Small print – Some providers seem to delight in creating ever more complex structures to market. As well as obfuscating some of the risks of the product, it can also allow them to slip in certain undesirable features, for example, the end value being the index&#39s lowest value over the last six weeks of the product&#39s life. This kind of feature has the potential to create real investor discontent in certain scenarios.

Growth products

These typically offer 100 per cent capital protection plus some participation in the rise of an index over a period of time, normally five years. These products are inherently simpler than most income products and have the obvious advantage that investors get their money back irrespective of market movements.

The absence of a yield will mean that these types of products will not be on the radar screen for a number of investors. That said, by staggering investments into a number of different products over a period of time, it would be possible to create a pseudo income stream from the staggered maturity payments.

This obviously takes some planning but might be considered worthwhile given the capital protection and tax benefits that this approach offers.


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