This is the first in a feature series, which will see key industry figures go head-to-head on topical issues. This month discusses the merits or otherwise of structured products
Marc Mears, senior manager, product manufacturing and development manager at Bristol & West 3rd Party Distribution, argues the case for structured products and why they are a valuable investment tool
Although some people question why intermediaries should recommend structured products, they are a fundamental element for capital protected investment planning. This is the view of Mears, who believes structured products do offer value for money and have their own niche place in the market.
Mears says: "Structured products come in a vast array of shapes and sizes from the very simple to the highly exotic and as such the reasons why they might or might not be recommended can be complex and manifold.
"There are in fact providers in the market who will create bespoke individual products for those who have a large enough principal to invest. A million pounds can buy an awful lot of choice in today's market; however, the main reason for recommending structured products in the retail financial services market place is protection."
Mears says more than 80% of all retail structured products sold are capital growth, capital protected products, which means the products have to protect a customer's capital.
He says, while a client's attitude to risk can vary, the different attitudes people take to their capital versus the possible growth are rarely separated. He explains: "An example might be a client who has inherited £15,000. They already have their day-to-day needs taken care of and emergency savings tucked away and this money has come as a windfall.
"However, they are not so wealthy as to be able to risk it all and the principal is not so great as to buy much in the way of portfolio diversification. As such they are very nervous about investing directly into shares. In this case, their only option would be a collective investment scheme, vanilla cash deposit or a structured product."
Collective investment schemes of funds come in a number of different forms, from unit trusts to life funds and with a huge range of investment remits.
Cash deposits have a similar amount of flexibility and are available from 30 days up to five years, according to Mears. He comments: "As a result of Ucits III legislation, structured derivatives can now be included in collective investments."
Mears admits funds have one advantage over structured products. He says: "It is well known structure products do not offer the greatest dividend yield and it is correct an investor does not get access to the dividends generated if their investment is linked to an index."
For example, most structured retail products link their return or part of it to the FTSE 100 index. A sensible estimate for the total return generated by the FTSE's divided yield over five years is about 15%.
Mears then argues that a customer who has invested in a FTSE 100 tracker collective investment scheme over a five-year period might be 15% better off than the person who has invested in a FTSE 100 structured product. However, he says funds that take charges from income will reduce the overall yield. Against this he points out the collective investment scheme does not offer the capital guarantee of a structured product. In essence, is it worthwhile for the investor to give up 15%, an opportunity cost, in exchange for capital protection?
"To many eyes this might well seem a price worth paying. However, investors can currently buy structured products offering 120% participation in the FTSE 100 index over five years, so the matter of lost dividend yield becomes irrelevant. In effect an investor is gearing into the market to compensate but without the downside risk of capital loss.
"It is true to say that there are those who have touted structured retail products as a silver bullet for investors, the magic investment to give to the world without any downside or cost. This is overstating the case, as there is always a cost to investing, whether it is charges, limited access, lack of dividends or reduced yields. However, if asked the question, do retail structured products offer value for money in today's investment market place, the undoubted answer is yes."
He concludes: "As ever, each client's needs are different and circumstances change. If this were not the case then advisers would be out of a job and everyone would be doing it for themselves. However, investors pay intermediaries to provide sound recommendations and value for money, so it is hoped structured products are not going to be ignored when recommendations are made."
Offer value for money and have their own niche place in the market
80% of all retail structured products sold are capital growth
Capital protection compensates for loss of divided yield
Peter McGahan, managing director of Worldwide Financial Planning, believes there are better returns to be had on other investment vehicles and argues against the use of structured products
While structured products are generally considered a less risky method of investing, McGahan thinks there is a price to pay for that.
He says: "Less risk normally means reduced returns for the investor. While it may seem a safe option for the investor to have a guarantee to receive their money back, historically how many six-year periods show a negative return? Who are they for? Does the customer really want them or does the adviser need them?
"So why would someone invest? For example, if a building society pays 4.5% on a savings account, minus 20% tax this leaves only 3.6%. If inflation is then running at 2% per annum, the real growth of deposit is only 1.6%. In other words, the buying power of a sum of money is considerably reduced."
However, McGahan says one way to increase the buying power or the gain to the investor is to invest in real assets. But he warns with real assets comes risk and the question of how much an investor wants to take on in pursuit of their gain.
He explains risk by defining the degree to which a fund can rise or fall, the potential for upside or downside. There are many factors that can increase risk, warns McGahan, including interest rates, inflation, politics, currency/exchange rates, liquidity in markets, confidence and general sentiment, investment philosophy and the capabilities/skills of the fund manager. Time is also a great healer, he points out.
"An investment that is to be held for 10 years will ride out many storms, whereas a shorter-term investment may not have time to recover from any falls, particularly if bought on an historic high. If an investor appreciates this and understands that potential for gain comes with fluctuation, which a good investment adviser can control, why therefore would they look for an invention that favours the market makers?" asks McGahan.
McGahan believes structured contracts are fundamentally flawed in many ways and says if investors want to beat inflation then they have to take risk.
He adds: "If a person comes across a plank of wood resting on the floor with a £10 note at the end of it, would the person walk to the end and pick up the money? The answer would clearly be yes, because the risk involved would be zero. However, would the same person walk across if the plank was hanging out a 30-storey window? The answer would probably be no."
In McGahan's view, this is a simple analogy for ascertaining whether there is sufficient reward for risk. He believes that by not picking the money up it is as bad as leaving it to rot with inflation. It is impossible to leave it on the floor and have the gain, so a conversation should ensue about what to give up and it is either the comfort or the expected gain.
He adds: "The main reasons why structured products are flawed is firstly the guarantee that they are being sold on does not come into play until the end of the term. If an investor tries to encash before the end of the term, and the market is down, they will get the appropriate guarantee - none. Secondly, how many six-year periods in history show a negative return? Not many at all. On that basis the guarantee is worthless as the market would be up."
Loss of dividends is also a real issue, warns McGahan. He gives the example of a FTSE 100 company, Lloyds TSB, which currently offers a 5.17% dividend yield. This means that over a six-year period the investor would receive a total dividend payout of 35.2%.
He explains in a guaranteed contract the investor would not have participated in this at all, so by taking out such a plan the investor loses 35.2% over a six-year period. McGahan feels this is hardly a good start for a plan that is supposed to be protecting the investor.
According to McGahan, there has also been a number of questions raised over the three-year term contracts. He says: "The risk involved with these contracts is poles apart from that of five- to six-year plans and it is hard to understand why they are offered. I believe the three-year kick-out plans are marketed incorrectly, as the consumer is actually led to believe this kick-out is a good idea. It is designed by the market makers to protect them and simply dumps the investor at a totally inappropriate time while the market maker providing the instruments is of course quids in."
Less risk for structured products can mean reduced returns for the investor
Loss of dividends is a real issue for structured products
Investors only beat inflation by taking on risk
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