The demand for protected products should continue to grow as long as intermediaries are prepared to take the time to educate investors as to the potential risks involved
Although structured plans have been around for many years, in one form or another, they have only recently become recognised as a specific asset class in their own right. Anybody who follows the personal finance markets will know that these plans have received a lot of attention recently.
As the investor on the street is often influenced by the latest information they have heard or read, they may go on to dismiss this very important area of investment based on insufficient and often misleading information. Indeed, following some of the recent press coverage structured plans have received, it would be easy to form a view that they should be avoided at all costs.
This is a very unfair view to take. Although some plans have suffered and will pay investors very little back, there have also been many other plans and many thousands of investors who have benefited from structured plans and who have fared extremely well with these investments.
Before looking at how plans differ, one should look into what they have in common. One simple answer is that structured plans, as their name implies, all have a set structure and a defined basis for future returns. Investors are therefore able to invest in a plan knowing at the outset how the final maturity payment will be calculated. Of course, this is not the same as knowing how much one will receive at maturity, although it does allow investors to know what they will receive based on the movement of the underlying assets the plan is linked to.
The plans are available over various terms, offer very different returns and are linked to a variety of underlying assets. The two plans below show the very different types of returns and objectives structured plans can have.
One plan aims to provide a fixed income of 6% a year plus a return of capital at maturity, providing the FTSE 100 Index does not fall by more than 50% over the five year term.
At maturity, the initial capital will only be reduced if the FTSE 100 Index falls by more than 50% from its starting level and then at a predefined one-for-one basis. Another very different plan aims to provide a return of double the FTSE 100 Index over five years, subject to a cap of 100% growth. This plan also allows the index to fall by 50% without the capital at risk.
While the way that the different structures work is difficult for most investors to understand, it is important that at outset investors understand the risk, the maximum potential returns they can achieve, and how these returns are calculated.
Risk is perhaps the area that has caused the most controversy with structured products and is also the most difficult area to deal with. This is because there are many factors to consider.
An important area to examine is risk to capital. This can vary from a total loss of capital, to a minimum return of the initial investment or, indeed, with some plans a minimum return of say 110%. There are many criteria determining when the capital is at risk. For example, take two plans linked to the FTSE 100 Index.
One may return the full capital providing the FTSE 100 Index does not fall by 50% or more over the term, while the other may require the Index to rise by 10% over the term in order to return the initial capital. On face value, the first plan looks the more attractive one. However, as with all investments, this is not necessarily the case, since the second plan may offer significantly higher potential returns and could therefore be more suitable to investors prepared to take more risk.
Variables of risk
The asset the product is linked to also plays an important part in deciding if its criteria are met. Although nobody knows the future, it is likely a plan linked to the Nasdaq will be higher risk than the same plan linked to the FTSE 100, because the Nasdaq is the more volatile index.
How the start and end levels are calculated also plays an important part in the performance of plans. These levels are often set using averaging over a set period. This can lead to a very different outcome to measuring on the first and last date of the plan only. Without the benefit of hindsight nobody can predict which product will produce the best returns, although it could be argued that averaging removes the risk of particularly sharp price movements during a particular day.
The financial strength of the institutions backing the products is often overlooked. However this can play an important part in determining how robust the product is.
The length of a product also affects risk ' a plan with a shorter term is often likely to be higher risk due to short term market volatility.
Compare two plans which offer seemingly similar terms but in fact have very different levels of risk. First take a plan which offers a minimum return of 70% of initial capital and a loss of 1% capital for each 1% the index falls, subject to the minimum of 70% return of capital.
Compare this with a second plan where all the capital is at risk, but the investor will not suffer a loss unless the index falls by 50% or more over the term, at which point there is a one-for-one loss of capital. Taking these two scenarios, it could be argued that the first option is higher risk, because the investor is much more likely to see some capital loss.
However, with the second option, although it is less likely that there will be a capital loss, it could be argued that this is higher risk as there is no limit to the amount of capital loss.
Of course, there is no correct level of risk as each investor will have a different set of criteria which is important to them.
The very different risks and returns of structured plans illustrate how unfair it is to judge the whole sector based on a handful of specific products. As with any asset class, there will always be both good and bad products.
When considering structured products, it is important to consider the alternatives available. We have, of course, had some extremely difficult and volatile stock market conditions over the last three years. Investors, who held shares in household names such as Marconi, Railtrack and Cable & Wireless have lost most of their money.
Even investors tracking the FTSE 100 have lost over 40%. Indeed, even investments that have traditionally been viewed as a good middle ground such as Zeros and with-profits bonds have suffered. Finally, returns from deposit accounts are also at historically low levels and likely to remain low in the near future.
So the downside risk to capital on structured products needs to be looked at in the context of what the rest of the market has done. In reality, virtually every asset backed/equity based investment that exists has an unlimited downside. Importantly however, unlike most conventional equity investments where the risks are very difficult to quantify, the risk parameters on structured investments are generally well spelt out and much more transparent.
So do structured products have a future? I believe the answer is definitely yes. Of course, anything that offers a return better than deposits is going to carry some risk.
However, it is down to advisers to make it clear to investors what these risks are and what they can receive in return for the risk. Based on this information, investors can invest into products, with their eyes wide open.
Investors should understand risk, returns and how returns are calculated.
Lifetime of product, backing institution and asset class used to determine risk levels.
Downside risk should be looked at in context of general market conditions.
Paul Bruns and Elaine Parkes
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