Structured products Problems with structured products
Is your capital protected?
Structured products can look very tempting, but just how safe is the money that you invest (the capital)?
Some structured products aim to return all your capital at the end of the term.
Others promise to do so only if certain conditions are met such as if the FTSE 100 index doesn't fall by a certain amount. These products tend to offer better returns but you may lose some of your capital. There are lots of different variations so make sure you read and understand any conditions. For example, some products will repay your capital providing the level of the index at the end of the term isn't 50% lower than the level of the index at the start. Others insist that if the index dips below the 50% barrier at any time during the investment term, then the index must return to the starting index level or higher in order to receive a full return of capital.
But even those products that aim to return all your capital can still put your money at risk. This is called ‘counterparty risk’ – usually it is not the plan provider but a third party who provides the guarantees. You, as an investor, do not have a direct relationship with the counterparty and if it goes bust then you lose your money and it's unlikely that you'd be able to make a claim under the FSCS.
Safer structured products
There are safer structured products. National Savings & Investments sells guaranteed equity bonds, a form of structured product. Basically, the Treasury is the counterparty and you can reasonably expect it to meet it's obligations to repay your capital and pay any income.
There are other products known as structured deposits, which don’t use counterparties. With these products, your capital is deposited with a bank, building society or credit union and you can generally expect your capital to be protected, up to £50,000, under the Financial Services Compensation Scheme. They also tend to marketed as guaranteed equity bonds. But you should always check the exact compensation arrangements as there are many different types of products around and whether compensation is available does depend on the way the product has been set up.
The cost to you
Capital protection comes at a price. When you invest in the stock market directly, you receive dividends from shares alongside any growth in the market. At the time of writing, you could expect 4% a year from share dividends in the FTSE 100.
But with most structured products you don’t receive the dividends – on a five-year product, for example, that means you miss out on more than 20% of the total return you’d get if you invested directly.
Some products also limit the return to a proportion of the growth in the index – for example, one product we found when we carried out our research offered a return of 70% of the index growth with a maximum growth of 40% of your original investment. With this product, you don’t only miss out on dividends, but at least 30% of the growth in the stock market as well.
And if markets fall, and you only get back your original capital, you will lose money in real terms because the value of your capital will have been eroded by inflation.
The price
All your money is invested for you but that doesn’t mean that these products are free. The providers take charges into account when setting the terms of the product. This can make it difficult to know what you’re paying. Some providers disclose fees but others don’t.
Returns
The returns you see advertised are not guaranteed. With growth products, your return will be linked to the underlying index, such as the FTSE 100. As an investor, it’s impossible for you to judge whether you are likely to receive the advertised growth rate or not. With the income plans, although you'll receive the advertised income each year, you may pay for this in terms of a reduction in your capital which effectively reduces your overall return.
Hard to handle
Some of these products are impossibly complicated. Alan Dick, director of consumer affairs at the Institute of Financial Planning, told us: ‘You need to be a rocket scientist to understand what's going on behind them. I don’t think consumers understand them. This may be the next mis-selling scandal.’
All or nothing
These products have a fixed end date and you get what you’re given at that point. Unlike a direct investment in the stock market, you can’t hang on in there and wait for the market to recover.
It is sometimes possible to get out earlier, but you may get back less than you invested. Although the product literature usually makes this clear, it's often much less clear how much you'd lose by doing so. You're likely to see descriptions such as this one we found: 'what you get back depends on interest rates and the prevailing market conditions at the time of closure.'
Structured product providers
We spoke to Morgan Stanley, a structured product provider, to ask what it thinks about the criticisms of structured products in general.
Marc Chamberlain, executive director at Morgan Stanley, believes progress is being made. He said: ‘These products are more simple and transparent now than they were. And there’s been a marked change in brochure design and clarity by most providers. However, structured products should be part of a wider portfolio of investments.’
Keydata
More than 5,000 investors who bought products from structured product provider Keydata have been told that their money is missing. Keydata was put into administration in June after the Financial Services Authority discovered that some of its Isa products may not have complied with tax rules, resulting in a potentially large tax bill that the company couldn't pay. Administrator PricewaterhouseCoopers (PwC) says it has found a host of other irregularities.
Most worrying is the possible disappearance of £103m invested in Keydata secure income bonds. The money was invested with a company called SLS Capital, which invested in US life insurance contracts through a bond listed on the Luxembourg Stock Exchange.
SLS has not paid any income on these products since October 2008 and PwC says it has information suggesting that the assets may have been misappropriated.
Neither the Financial Services Compensation Scheme (FSCS) nor the FSA have confirmed whether investors will be able to make a claim through the FSCS. The FSCS published an update on the situation on 25 August 2009, stating that it is still investigating whether investors may have a potential compensation claim.
It says that investors do not need to contact the FSCS at this stage. The FSCS will update its website as soon as any new information becomes available. It says that it will provide a further update via its website by the end of September 2009, if not sooner. Even if a claim is possible, the maximum compensation is £48,000. PWC's website has updates on the Keydata situation.
Which? Says
The risks of structured products must be spelt out. Some providers who use counterparties still promote their products with words like ‘protected’. This is misleading and should be stopped.
Don’t invest your money in one of these products without getting independent financial advice. Even then, make sure you ask questions about who is providing the guarantee, what compensation arrangements are in place, and how much you’re effectively paying for the guarantee in reduced returns.
We’re also concerned about investors who have lost money as a result of Lehman Brothers collapse. The Financial Services Authority and Financial Ombudsman Service announced that they would review the sale and marketing of the products backed by the bank. The FSA said in August 2009 it was deferring a decision on this for three months.