Defaqto

Background

Structured products are investment vehicles designed for investors who wish to combine the potential upside of strong stock market growth with a guarantee that they will get their original investment back.

The investor places money into an investment fund which is designed to mature at a specified future date - usually five to six years’ time.

Most of your capital is invested in a low risk bond, which offers a guaranteed return over the term of the structured product. Usually, the guarantee is that the original investment (the ‘capital’) is protected and will be returned to you at the end of the investment term.

For example, if your capital investment is £100, and part of this money is invested in a bond which offers a guaranteed 20 per cent return over the life of that product, then £83.33 will be invested in the bond. When the structured product matures, the bond will be worth £100.

The rest of your capital (£16.66) is invested in more high risk instruments such as hedge funds, private equity or derivatives to boost performance.

Mitigating risk

Typically, the low risk element of a structured product is in the form of a zero coupon bond, which pays no dividends, but has a set redemption value.

The risk capital (the remaining part of your capital) could be invested in hedge funds or futures contracts on an index such as the FTSE 100 or a commodity.

While these offer the potential for high returns, they entail the risk of high loss, so the money set aside to cover these risky investments much be sufficient to cover any potential losses.

Using options

Options, which give you the right to buy or sell an asset at a future date, are often popular ingredients of a structured product, since the downside of these investments is built into the initial price.

Returning to the above example, a £100 structured product, with £83.33 invested in a bond, would entail a £16.66 purchase of an option. If the option is to buy a specific asset, and this asset then falls in value, then the option will not be taken up and the £16.66 initially paid out will be lost.

If on the other hand, the price of the asset goes up, the option may well be exercised, and the profit will equate to the difference between the market price when the option is exercised, minus the price of the option at the outset, less the amount paid for the option.

In practice, however, many structured products entail a maximum and minimum potential return. This means that you know the best and worse possible outcomes for your investment. This is a nice ‘peace of mind’ feature,  but remember that guarantees cost money and that by limiting the downside, they are also limiting the potential upside.

Example of a structured product

A typical structured product sold in 2007 was the Arc Capital & Income Bull & Bear Tracker Plan 2,  promoted by IFA firm, Chartwell. The aim of the investment was to provide:

• 100 per cent of any capital growth in the FTSE 100 over a 6 year term, or,
• a 1 per cent return for every 1 per cent the FTSE 100 falls up to a maximum of 50 per cent.

Your initial investment is 100 per cent protected, if held until maturity. So at maturity, the only circumstances in which you would not make a profit are:

• if the final value of the FTSE 100 index is exactly the same as the initial level; or
• if the FTSE 100 index falls during the 6 year term by more than 50 per cent and the final level is not above the initial level. Even if this happens, your capital is secure.

(Final index values are averaged over the last 13 months in order to smooth final maturity values).

Capital protection

For example, on a £25,000 initial investment, if the final FTSE 100 index (after averaging)  is 55 per cent higher than the initial level, you would get back your£25,000 capital, plus 55 per cent growth (£13,750), giving you a total return of £38,750.

By contrast, if the FTSE 100 index fell by 35 per cent from than the initial level (but had not fallen more than 50 per cent below the initial level at any time), you would get back your initial investment of £25,000, plus 35 per cent (£8,750), giving you a total return of £33,750.

Alternatively, if the FTSE 100 index were to fall during the 6 year term by more than 50 per cent, and the final level is not above the initial level, you would still receive your £25,000 capital back. However, investors are required to hold the investment until the end of the 6 year term for the return of capital guarantee to apply.

Precipice bonds

Although structured products are meant to mitigate against potential losses, some structured products have had the opposite effect.

‘Precipice bonds,’ which were popular in the 1990s, offered investors high potential rewards by tracking certain indices, which had enjoyed strong growth during the bull market of the late 1990s. But when some of these indices fell by up to 80 per cent, as they did in the 2000-03 bear market, some precipice bonds left investors with catastrophic losses.

Derivatives

Derivatives are contracts to buy, or sell, a certain share, bond or commodity at a future date. Typically, when we think of derivatives, we think of the futures market.

But derivatives include futures (options), swaps and warrants which, when correctly used, can reduce risk.

Futures

For instance, companies, insurers and farmers use futures, a derivative product, to guarantee the price of commodities such as wheat, coffee, oil and gas. That way they know that, even if the market price of oil soars, they will be able to buy it at a price agreed in advance, allowing them to plan ahead with a degree of certainty.

In a similar way, businesses can use derivatives for future currency purchases. A UK based business might want to hedge against currency fluctuations affecting the cost of a purchase from a US-based supplier at certain date in the future.

He may worry that the dollar/pound exchange rate will increase the sterling price, so he takes out a contract to buy US dollars at a certain price on the day that payment for the widgets is due.

Other derivatives include:

Options

An option provides the option holder with the right, but not the obligation, to buy or sell an asset at a  specified future date.

Swaps

Swaps are where two parties agree to exchange cash flows. Most commonly, swaps entail a swap in interest rate flows relating to two different currencies.

Warrants

Covered warrants, allow you, in return for a premium, the option of buying or selling shares at a fixed price at a specified future date.  If, at this date, the shares are more expensive than the price agreed at the outset, you make a profit.

Warrants also allow you to gain exposure to a large number of shares for a fraction of the price, which can be useful protection against falling share prices.

Sometime warrants are bundled together with another class of security to enhance the marketability of the other class. Warrants are like call options, but with much longer time spans, usually a few years.

Contracts for difference (CFDs)

A contact for difference (CFD) is a contract to buy or sell a share, or other asset, at a future date.

When you enter into a CFD you can either go ‘long’ or ‘short.’  If you believe the stock is going to rise ( ie you go long), you pay an amount at the end of the contract that equates to the asset's price at the time you entered the agreement contract, minus the price when the contract ends.

If the price rises, as you expect, then the difference will be negative, and when you close the contract you have made a profit.

Typically, a CFD requires an upfront payment of 10-20 per cent of the market price of the asset at the time of purchase. Because this initial payment represents a small percentage of the value of the contract, a CFD is known as a ‘margin’ product, and when you buy a CFD, you are said to be trading ‘on the margin.

ADRs

Another popular form of derivative is the American Depository Receipt (ADR), which is the way in which the stock of most foreign companies trade on US stock markets.

They are issued by US depositary banks, and represent the shares of foreign stocks. Investors who purchase them have the right to obtain the foreign stock it represents, but UK investors usually find it more convenient to own the ADR.