While risk-averse investors are being steered toward more structured products as providers tap into their need for a guaranteed return, there are areas where investment newcomers need to be wary
With cautious or risk-averse investors still chasing double-digit returns without taking the inherent risks of stock markets, many advisers can be pushed down the product curve in order to satisfy consumer demand.
Add to this the continued nervousness of investors and their lack of confidence in equity markets, which has been supported by the latest reports of falling Isa sales, it is not surprising investors are looking for alternatives.
In answer to these calls, providers are jumping on the latest bandwagon and, as a result, we have seen an increase in the launch of structured products, otherwise known as guaranteed/protected or high-income funds.
While most intermediaries are aware that in a low inflation, low interest rate environment, headline rates are often not achieved without risk, few investors will understand this.
Now is the time to educate investment newcomers, who are enticed by the promise of double-digit returns and expect these to be achieved with no risk to capital. It is always easy to forget there is no such thing as a free lunch.
Advisers and investors face the same dilemma of finding an attractive alternative to equities that has the same perceived risk as cash. This is where structured products can provide that crucial middle ground, offering protection on capital invested, while benefiting from increases in stock markets.
On the face of it, such products seem a lifeline for battered investors. But, in practice, things are not as straightforward as they seem. The potential problem lies in the products' popularity. They should be crucial and effective stepping stones for investors moving from cash to equity but in reality are increasingly becoming provider, rather than consumer-driven.
Although there are various options and types of structured products available with different ways of structuring dependent upon the objective, the underlying concepts and structure that lies behind the smoke and mirrors of the headline rates are very similar.
The diagram above helps illustrate the basics of how the money is invested to achieve the returns. This all may seem fairly simple but there are problems. With falling interest rates, more money is having to be placed on deposit with the counterparties to achieve the interest rate swap to return the required capital by the end of the term. This leaves less money for buying the derivatives, which are becoming more expensive because of increased volatility.
These two fundamentals are the drivers to the increasingly complex nature of the products and heightened difficulty for their manufacturers. A pat on the back to product development teams across the City, but the beasts they are creating are more cunning, with more onerous criteria and complex hurdles before they will begin to bear fruit.
In spite of all this, these products are supposed to be suitable for the risk-averse investor. And, worryingly, this is still how they are sold to the public and perceived by them. Here are perhaps some of the obvious tricks of trade to look out for:
• Indices: Most structured products evolved from the use of returns simply linked to the UK, usually the FTSE 100. Due to the increased cost of derivatives, the result is the use of multi-indices, commonly markets in the US, Europe, Japan and so on. This is often referred to as diversification, but in reality is a trick of the trade to create more margin or profit for providers and distributors. With any basket of indices or stocks, there is an increased risk that there would be a rogue return which will negate some of the upside of other indices or stocks. It is obvious that use of indices such as the Nikkei and particularly the Nasdaq is dubious and questionable for inclusion in a low-risk product.
• Averaging: This is the process where the returns of the product are not simply the returns calculated from start to finish of a particular stock or index for the term. But, in fact, it is an average of returns over a specified period. It is often referred to as the smoothing of returns. As to what is the best amount of averaging used ' this will only become clear in time but is something of which investors should be aware of.
• Participation: There are generally two clear choices: Investors can be offered 100% participation in the growth of any index being used. It is worth mentioning there is an increasing use of a cap on the total rise. Uncapped participation of the index being tracked but only with a percentage participation of 50%-80% of growth. Bear in mind though that there are pros and cons for both, including future economic environments, and prospects of growth.
• Term: The common term is five years but shorter terms are increasingly being used. The shorter term can mean an increased exposure to risk and make derivatives cheaper. Another word of caution is the increased use of such terms that are not whole years, three years and five days.
• Gearing: Check the small print. This relates to the downside risk, and what is frequently appearing is that if there is a 1% drop in the index, there is a 2% drop in the capital. There is usually downside protection if there is a drop in the index of 20%-30%, after that the gearing kicks in.
Fundamentally, there is nothing wrong with structured products and innovation and choice should be applauded. However, with the increasing use of complex structures, caution has to be taken and a better understanding of these products is clearly required.
Kerry Nelson is associate director of Deep Blue Financial
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