Money tip #102 – Why you should avoid structured products
The chances are that you have either received an invitation from your bank to invest in or read something in the press about structured products. These investments are often dressed up as the Holy Grail in today's uncertain markets. They give the investor access to returns based on the investment markets while at the same time protecting them from losing their money. But before you get all excited let's take a closer look.
What are structured products?
The FSA’s Money Made Clear website describes them as:
‘’Structured products offer returns based on the performance of underlying investments. Many products are linked to a stock market index such as the FTSE 100. The underlying investments may involve different firms based in various countries.
A typical structured product will have two underlying investment components:
a note – (a type of debt security). This component is used to provide capital protection. It may pay interest at a specified rate and interval, and may repay some or all of your original money at maturity. Some offer 100% capital (or ‘hard’) protection while other offer partial (‘soft’) protection i.e. your original capital is at risk.
a derivative – (a financial instrument linked to the value of something else, such as a stock market index or the price of another asset, such as oil or gold). This component is used to provide the potential growth element that you could get at maturity.
Investors are usually offered only a share of any increase in the level of the index or asset price which occurs during the term of the investment.’’
Can you give me an example?
An example of a structured product currently on the market has the following characteristics:
- You get 100% of any rise in the FTSE 100 after 5 years subject to a maximum of 52.5% of the initial investment.
- The Initial Index Level is the closing level of the FTSE 100 on 19 October 2010.
- The Final Index Level is the average of the closing levels of the FTSE 100 on each Business Day from, and including, 23 April 2015 to, and including, 23 October 2015.
- Your initial investment is protected against any FTSE 100 decline at maturity
Sounds great, but what’s the catch?
You’re right there is a catch, in fact several:
- They are complicated – as alluded to earlier these are complicated investments so don’t be fooled by their apparent simplicity. Providers will use all sorts of tactics such as using averages to determine the final index level which your returns are based on. In a rising market you could lose out. As a rule of thumb, if you don’t fully understand something than it’s best to seek advice or avoid altogether.
- Counterparty risk – a product is marketed by a ‘plan manager’, but the returns and guarantees are normally provided by a third party, called the counterparty. Now while this is made reference to in the small print of the product, investors still may not fully take on board the implications. If the counterparty goes bust then you will likely lose your money even if the product offered 100% capital protection. If the company offering the protection goes bust then its promises aren’t likely to be worth more than the paper they are written on. Especially because counterparty default is not usually covered under the Financial Services Compensation Scheme (FSCS). And don’t think it can’t happen, when Lehman Brothers went bust they took a host of structured products with them.
- Loss of dividends – given that most equity based structured products don’t provide any dividend income you are missing out especially when you consider that most of the returns from equities over the long term have been via dividends and not capital growth.
- You’re locked in – a lot of structured products lock you in for a period of time. Consequently it is almost impossible or expensive to get your money out before the maturity date as there is no secondary market for private investors to sell onto. That also means that if your structured product’s ‘protection’ has been breached you can’t do anything about it and just have to watch your money trickle away.
- They are expensive - the charges on these products are not explicit and are rolled into the terms of the contract. This lack of transparency means that investors can’t see how much they are being charged by the investment provider. But I can answer that question for you………the answer is ‘a lot’.
What’s the alternative then?
If you like the idea of some exposure to investment markets, such as equities, while not exposing all your money to the risk of it disappearing in the next market crash, you could always invest some of it in tracker funds, for example, while keeping the majority tucked away in a safe haven, such as a deposit account. If in doubt, seek financial advice.
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