Structured products: Is this an offer you can't refuse?

A guaranteed investment looks good in volatile times. But be wary, says James Daley

Global stock markets have been terrifyingly volatile over the past year. In the UK, after climbing above 6,750 in July 2007, the FTSE 100 index slumped to below 5,350 in January. Since then, it has twice jumped above 6,000 and then fallen back again.

In spite of a rally since the start of this month, the index is still more than 7 per cent below its July peak, and it remains highly sensitive to any bad news.

Such volatility has led to many cautious investors cashing in their equity investments, hoping to find shelter in lower-risk asset classes. But deciding where to reinvest hasn't been easy. With commercial property in the doldrums, and the corporate bond sector still relatively shaky, investors in search of superior returns for not too much additional risk have been left with few options.

Such difficult conditions have played into the hands of investment products that offer capital protection or guarantees. At their best, these so-called "structured products" offer to pay back customers all of their initial investment if stock markets fall, as well as most of the gains if markets rise.

But, while their advocates say they represent the holy grail of investment, some advisers believe they are too complex for their own good.

So what are structured products?

Structured products are typically fixed-term investments that offer investors some protection on their capital. Overall returns are usually linked to the performance of an index or basket of stocks over three or five years. However, if the underlying investments fall, investors usually still get most or all of their money back at the end of the term.

For example, the Barclays Protected FTSE plan promises to pay you 1.5 times any growth in the FTSE 100 index over the next five years, up to a maximum of 51 per cent. But if the index finishes lower than it began, you still get all your initial investment back.

What's the catch?

The obvious catch is that – just as your downside is limited – so is your upside. Hence, if the FTSE doubles over the next five years, Barclays' plan will only pay you a return of 51 per cent.

Furthermore, points out Mark Dampier, head of research at Hargreaves Lansdown, the Bristol-based stockbroker and adviser, structured products do not pay any dividends. "They give you no dividends, which accounts for about 20 or 30 per cent of the total return of investing in the FTSE 100," he says. "And it's important to remember that even if markets fall and you get your money back in five years, that's still a loss in real terms [when you take inflation into account]."

Nevertheless, many of the more sophisticated products offer to lock in any gains each year, while the gearing element of structured products can also help to generate strong returns that will make up for any loss in the dividend.

For example, Blue Sky Asset Management, which launched last year, currently offers a product called the Accelerated Recovery Plan, which is linked to the fortunes of five banking stocks and which offers investors 1,250 per cent exposure to their returns. This means that, over the next five years, the portfolio of banks needs only to grow by 10 per cent for investors to get a return of 125 per cent. Although there's also a capital guarantee, the downside is that if one of the bank stocks falls by more than 50 per cent during the period, investors stand to lose more than half of their money.

As the graphs above show, the share prices of these banks have all fallen sharply over the past 12 months, but that doesn't mean that they can't continue to fall.

Chris Taylor, the chief executive of Blue Sky, says that even structured products with more modest payouts have a place. "In terms of the dividend – yes, I agree that in a total return market, a plain vanilla structured product does not necessarily represent good investment value for an experienced investor," he says. "But for a cautious investor, it may still make a good stepping stone away from deposit accounts."

How do they work?

Most structured products work by investing the majority of a client's money into a bond or cash deposit account, which will grow by enough to cover the capital guarantee once the product matures. For example, if you were to invest in a five-year guaranteed equity bond, the provider might invest about 75 per cent of your money in an A-rated bond, paying just under 5 per cent interest per year. By the end of the five years, this bond would have built the 75 per cent back up to the full value of your initial investment.

The manager would then use the remaining 25 per cent of your investment to try to generate an additional return. Through the derivative markets, the managers can leverage their position – meaning that they need only to invest a small amount to get a large exposure to an index or stock.

In most cases, any upside will be limited. Blue Sky's Accelerated Recovery plan pays investors a maximum of 125 per cent return; anything on top of this will be profit for them.

What are the risks?

Although most structured products talk about "protecting" or "guaranteeing" your capital, it's important not to mistake this for a complete removal of risk. As Hargreaves Lansdown's Dampier points out, even with products that come with 100 per cent capital guarantee, your capital will still have been eroded by inflation if that's all you get back after five years.

Some structured products also have additional investment risk, whereby you can lose a much greater value of your investment if the underlying index or basket of stocks falls by a certain amount. For example, you might be guaranteed all your money back as long as the underlying index doesn't fall by more than 50 per cent during the lifetime of the investment. But thereafter, you could see virtually everything wiped out.

Back at the start of the decade, thousands of British investors lost thousands of pounds in products such as these, known as "precipice bonds". So it's very important to read all the small print and understand exactly what you're getting into before you buy one of these products. Although the precipice bond scandal – which saw Scottish Widows fined £2bn for mis-selling – sent a shock wave through the industry, there is still a big difference between the products on the market – some are much more risky than others.

The other danger with structured products, says Blue Sky's Taylor, is "counterparty risk". The guarantees behind most such products are provided by a third party (ie, not the company you put your money with), and if any of those third parties go bust, your guarantees may not be met.

But Taylor plays down this risk. "The counterparty risk is no greater than putting money on deposit with a major global investment bank," he says. "Shareholders can lose all their money, but evidence suggests that governments and central banks view the importance of the banking system to such a degree that they're openly committed to supporting it."

However, it's worth noting that, while you would be protected by the Financial Services Compensation Scheme if you put your money directly with a bank, you would have no such protection if that bank went bust while it was providing a guarantee for your investment with a different company.

Where do these products sit in a portfolio?

Some advisers believe that there really is no place for these structured products in a regular portfolio. Hargreaves Lansdown's Dampier, for example, questions whether investors should ever buy products that they do not completely understand.

However, Brian Dennehy of Dennehy Weller, the London-based financial advisers, is more bullish. "I've never had a problem with protected investment products, but I prefer the ones that are straightforward, giving you clean exposure to an index such as the FTSE 100, and offering you 100 per cent of the index's returns, or maybe more, with your downside protected," he says.

"They fit very well into the lower-risk end of a client's portfolio – particularly in the build-up to the credit crunch, when we thought we might have seen the best of other lower-risk assets such as corporate bonds and property. Then, after the credit crunch, the simple products started to disappear, because the cost of the underlying guarantees was becoming so high."

But Blue Sky's Taylor believes that the more inventive structured products are where the real value is – products that can give consumers access to markets that they might usually struggle to buy into directly, such as commodities and emerging regions.

How can I find out more?

Many high-street banks will sell you structured products in their branches, but the best way to ensure you get the best product for you is to go through an independent financial adviser. To find one in your area, visit www.unbiased.co.uk. You can buy some structured products from asset management firms directly, but will often need to sign a disclaimer showing that you understand the risks.

For listings of products currently on offer, visit www.trustnet.com/sp