In today's economic climate, structured products are increasingly being viewed as a solution to investors' demands for meaningful returns with low downside risk.
For many investors, the market falls of the past few years have had serious repercussions on the value of their investments. The FTSE 100 index has lost around 30% over the past three years and the consensus seems to be that returns in the future will be more modest. Many investors face the dilemma of how to recover this lost ground without speculating on a high-risk venture.
Investors could move their money into a building society where money is secure (but returns are unlikely to be earth-shattering), or could just sit and wait for markets to recover. Either way, recouping their losses could take investors some time and actually making a profit would take even longer.
Looking at alternatives
Definitions across the industry of what a structured product represents differ, but they tend to have two common themes. First, they are designed to provide exposure to the performance of the stock market with a pre-determined level of capital protection - all of which is calculated by reference to the closing level of the index at the end of the product's term. Second, the products can be designed to offer growth, income or both.
There seems to be a big taste in the industry at the moment for structured investment products. In 2002, these products attracted over £6bn - and have displayed a year-on-year growth rate of 17% since 1994.
2003 has seen a large amount of product launches and many new entrants to the market, and interest has never been higher.
So what kind of return does a structured product offer? Options available in structured products include growth and protected. For example, in a typical product the growth option aims to provide an opportunity to participate in returns linked to the FTSE 100 over a six-year period. For each 1% rise in the value of the FTSE 100, the option will return 10% subject to a maximum of 50% of the initial investment. At the end of the plan term, if more than 50% growth in the FTSE 100 has been achieved, investors will fully participate in the additional growth of the FTSE 100 on a one-for-one basis with no upper limit.
For example, a typical protected option within the plan aims to provide an opportunity to participate in returns linked to the FTSE 100 over a six-year period. For each 1% rise in the value of the FTSE 100, the option will return 1%, with no upper limit.
The money is invested in securities known as medium-term notes, which are debt instruments issued by financial institutions. These notes have been structured with the necessary characteristics which aim to match the advertised returns to investors.
The product is increasingly seen as a suitable solution for the needs of a growing number of investors. It is hardly surprising investors want their money to work hard, but in today's economic climate, they can find it difficult to know where to turn.
In the 1990s, things seemed rosier - the strong growth in equities in the late 1990s provided an attractive home for investors' money - UK equities achieved double-digit growth in eight out of 10 years with a compound annual rate of return of nearly 15%. The subsequent year-on-year decline in equities has perhaps shaped the view of a whole generation of investors and the decline in global stock markets has shaken confidence and made retail investors a great deal more cautious. So the problem for investors is how can they get a meaningful and attractive return in today's market.
Putting money in a typical deposit-based savings account is not going to generate astronomical growth. In general likely stock market growth suggests a return of 7-8% for the future, based on the assumption that companies can grow their profit by a rate similar to the rate of expansion of the economy at around 2.5% pa. Adding in inflation at a target rate of 2.5% leads us to a nominal GDP growth rate of 5%. Additionally, companies tend to strive for productivity and efficiency, so there is probably an additional 2%-3% profit growth available.
the risks of investing
So for investors looking to recoup the value of their savings, the stock market offers the most rewarding prospects, but are investors willing to take the associated risk? It is likely equity markets will see periods of rapid gains interspersed with setbacks and consolidation and investors need protection from this volatility. It is therefore easy to understand why an investment solution that offers access to the upside of the stock market with a level of capital protection has a strong appeal. With this demand, more advisers are keen to understand the nature of these products better, and as their knowledge increases, they are becoming more confident about entering this market.
Of course, it is important we learn lessons from the past and apply them to both the manufacture and sale of these products. Investors should be made aware that capital protection does not always provide a cast-iron guarantee. They should understand the product provider's ability to deliver the promised return depends on the ability of the counter-party to meet its obligations. Investors may take comfort from the high credit rating of the counter-party, but they should still be made aware this risk exists.
So the demand for structured investment products has been rising, but what is the outlook should equity markets continue to recover?
Research shows the extent of losses sustained over the past three years will mean that the value of protection is still appreciated by investors. For many investors, a level of protection for capital is now paramount either because they are now more risk-averse, or capital protection is critical for their lifestage.
Other key developments are likely to continue to stimulate the market. In November 2002, the Financial Services Authority (FSA) adopted the Ucits Product Directive, which reforms the regulation of collective investment schemes to allow a greater range of fund types, including guaranteed and limited issue funds. This environment should facilitate the development of a new range of capital protected funds.
From an intermediary's perspective, it is clear that in the past a high percentage of sales of structured investment products were sold directly, but it is also clear many investors did not fully appreciate the risks associated with the plans they bought. Intermediaries have a potential opportunity here as those investors may now turn to them for advice on where to go next.
It is reassuring the FSA is proposing to collect detailed information about sales of all financial products as this will mean new trends and potential problems in retail finance will be identified more quickly.
In general, the structured investment product market is a good solution for some investors in the current climate and, as mature products, structured investment products rightfully sit alongside others as part of the suite available for intermediaries tailoring investment solutions for their clients.
In 2002, structured products attracted over £6bn of investment and they have displayed a year-on-year growth rate of 17% since 1994.
Ucits regulation should facilitate the development of a new range of capital protected funds.
Investors should be made aware that capital protection does not always mean a cast iron guarantee
Consultation closing 15 September
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