Structural faults

Structured products are still seducing investors in these troubled times.
Sonia Speedy detects distinctly diverging feelings about the asset class

With the turbulent markets sending investors scampering to safe havens, the protection touted in structured products had been looking rather alluring. But the Lehman Brothers’ collapse has brought the security they purport to offer into question, prompted calls for advisers and clients alike to look deeper under the hood of such products before signing up.

Structured products work on the basis that investors receive a return tied to the performance of a particular indicator – most commonly the FTSE 100. With capital secure products, as long as the product is held full-term the investor gets all of their capital back, even if the value of the indicator finishes up lower than when they began. If the FTSE 100 rises, investors benefit from the upside. Capital secure structured products include guaranteed bonds and fixed income bonds and are particularly popular currently.

For investors willing to take greater risks in the hope of making more significant gains, capital at-risk products are more highly geared. A level of protection is still offered – with the industry standard being a 50 per cent protection barrier. This means the market would have to halve for investor capital to be at risk.

Structured products can also fall under differing tax regimes, with those structured as bonds being taxed as bonds, while others fall under capital gains tax rules. Those structured as bonds are also afforded more consumer protection than other structured products.

But it is the element of capital protection offered by structured products that has proven to be the draw card for many investors struggling against the backdrop of global market meltdowns and low interest rates on savings.

Figures from StructuredRetailProducts.com show that in 2008, more than £8.4 billion was invested in structured products in the UK. This compares to close to £6.7 billion in 2007 and just under £5.2 billion back in 2005.

NDF Administration is a specialist in structured investment products. Its marketing manager Ronan Gelling describes the sector as having picked up “incredibly”. “Initially I think it was because when the market started to fall, people became a little bit disillusioned with ordinary funds. They were looking for capital protection and preservation,” he says.

He also believes investors wanted greater value for money. “With funds, you’ve got the annual management charge and the bid/offer spread, whereas with structured products all the fees are built into the product itself. Also people are very attracted to a defined return and risk,” Gelling says, although some would argue that simply makes them less transparent in terms of charges.

The fact that investors have the best and worst case scenarios explained to them upfront is an additional draw, he says. But the collapse of Lehman Brothers, a counter party for structured products offered by companies such as NDF Administration, has left confidence shaken. As Whitechurch Securities managing director Gavin Haynes points out, investors in structured products backed by Lehman are also not entitled to seek compensation through the Financial Services Compensation Scheme (FSCS). Gelling agrees the collapse has not done the market any favours.

“However, sales have held up. Those people who understand structured products are still selling them. It hasn’t affected it as much as people thought it would have done,” he says. Gelling believes that Lehmans’ collapse has woken people up to counter party risk and to understanding the ratings of the financial institutions behind these products. “People are delving in a little bit deeper to know who the investment bank is, who the issuer is, and where the risk lies,” he says.

Institute of Financial Planning (IFP) director of consumer affairs and Forty Two Wealth Management certified financial planner Alan Dick warns that investors and advisers need to tread carefully. “Investors don’t get something for nothing,” he warns.

He says structured products can be opaque and encompass a number of risks for investors. This includes the strength of the counterparty involved, lack of liquidity, hefty penalties for early exit, and the fact that the actual cost of the guarantees built into these products can be difficult to ascertain while the potential upside is limited. “My own personal view is they have no place in my clients’ portfolios. I just won’t entertain them,” he says.

Informed Choice joint managing director Martin Bamford shares similar sentiments. “They’re very difficult to compare like with like. They’re not particularly transparent and we have some concerns about investor understanding about what they set out to deliver,” he says. “I don’t think it’s ever really possible to break that link between risk and reward and the sooner that advisers and their clients accept that, the better.”

Meanwhile, in an IFP statement, Dick said: “We are worried that such low levels of interest are likely to drive many investors into complex and opaque structured products, such as those provided by banks.

“These products offer a fantastic opportunity for product providers to make a profit and rebuild their balance sheets at the expense of investors who generally get a poor deal,” he said.

But Dick and the IFP are not the only ones issuing notes of caution. Both the FSA and Investment Management Association (IMA) have done likewise. The IMA has aired concerns that structured products are not transparent enough and that retail investors might not understand the risks involved. It also called on the FSA to regulate structured deposits.

In a speech at the 6th Annual Structured Retail Products Conference in February, FSA asset management sector leader Dan Waters said the FSA also feared consumers might not appreciate that capital protected investments were only as robust as the guarantee provider behind them, and that consumers could fail to understand the “implicit costs” of capital preservation.

“Especially the likely reduction in total returns compared with similar risk products in the long term,” Waters said. The FSA says it has been collecting data on products affected by the recent Lehmans’ failure and is considering the quality of marketing material and risk disclosures in communications issued for the products affected.

“We know some firms think there are regulatory blockages that stop investors or their advisers knowing which institution or institutions have issued the debt that makes up the capital protected element of a particular product,” FSA spokesman Robin Gordon-Walker says. “We are not convinced that there are in fact such regulatory blockages. However, we want to understand what firms think these might be and why firms think they apply.”

At the same time, Treasury Select Committee chairman John McFall has called on the FSA to investigate structured product sales.

But Investec Fund Managers managing director David Aird suggests protected funds can offer a useful alternative. The Investec Multi-Asset Protector fund offers diversity, liquidity and transparency of charges, as well as 80 per cent capital protection, he says.

“It’s not 100 per cent, but the nice little twist is that we’re not just protecting the capital that was invested, our 80 per cent guarantee actually rises as the value of their portfolio rises,” he says.

But Haynes believes all structured products should not be tarred with the same brush as they differ significantly, both in what is offered and in structure. Historically Whitechurch has put together a monthly list of recommended structured products for its advisers, but this has been suspended due to the difficulties of accurately assessing the associated risks.

“We’re not using them at the current time until the clouds clear and we become more confident with the institutions issuing them,” Haynes says.

However, he added it would be more inclined to use structured products underwritten by the provider – rather than a third party – as was the case with products from HSBC, Barclays and Investec.

Summing up the approach to structured products currently required, Haynes says: “Each one has to be looked at individually regarding the terms of the product and more importantly than ever, the issuer and how it is structured.”

Adviser View: Matthew Woodbridge, head of investment products, Chelsea Financial Services

“There are lots of plans out there. They’re not a one- size-fits-all but depending on the adviser, there are certainly some attractive opportunities”Part of a balanced portfolioChelsea Financial Services head of investment products Matthew Woodbridge believes structured products still offer efficiencies for advisers and investors in creating a balanced portfolio.

“You do get defined returns with capital protection and especially if you have a flat market you can get accelerated returns, where you don’t need the market growth to generate product coupons,” he says.

“Indeed in some of the products we’ve seen recently there can even be negative market performance which produces a positive coupon for investors,” he says.

However, Woodbridge agrees such products are not without risk and advisers and investors need to take care to check out who the provider is, the protection level of counter party risk and to make sure the investment is being made in conjunction with other investments and not in isolation.

But he says providers are moving to salve investor concerns, such as those around counterparty risk, with products emerging that have Government gilts as the counter party, for example.

“There are lots of plans out there. They’re not a one-size-fits-all, but depending on the adviser, there are certainly some attractive opportunities out there, particularly with the market as low as it is at the moment,” Woodbridge says.

Products he favours currently include the Morgan Stanley FTSE Defensive Gilt-Backed Growth Plan. This plan offers a potential nine per cent return each year of the three year term, as long as the FTSE 100 does not fall by more than 10 per cent on each annual anniversary of the plan. If at maturity the FTSE 100 has not dropped by 50 per cent or more since the start date, the initial investment is protected.