Smart Thinking... The price of protection
Not all structured products are “precipice bonds”
Structured products have gained something of a bad
reputation in the past couple of years. The schemes
work by putting around 75 per cent of your money on
deposit to provide capital protection and then use
25 per cent to buy derivatives linked to stock
market indices such as the FTSE 100 and Eurostoxx 50
to provide attractive returns over a set period of
between one and five years. The remaining 5 per cent
is typically eaten up by costs.The concept of stock-market-linked returns without any of the risk was almost irresistible, and these schemes became very popular with cautious investors during the mid-1990s. But, as demand grew, product providers started offering higher and higher yields, often in excess of 10 per cent and often without making it clear to investors that their capital was at risk if markets fell sharply. This didn’t matter during the bull markets of the late 1990s; but as share prices started to fall in 2000, investors in these bonds realised that their investments were not quite as safe as they had hoped. Many of the schemes provided capital protection – but only against market falls of around 25 per cent which, when the products were offered to investors, seemed a very generous margin of loss. Once these protection limits had been breached the schemes lost significant sums – sometimes twice the level of the stock market’s decline.
Unfortunately, many investors put money into these schemes – also known as ‘
precipice bonds
’ – without getting advice first. This meant they had no comeback against the firm selling the product. But consumer watchdog the Financial Services Authority is taking action against firms that sent out misleading marketing material, and this has resulted in compensation for some investors. While experts say the precipice bond scandal should serve as a warning to investors to look at products very closely before committing their cash, they also argue investors should not throw out the baby with the bathwater.“There’s a huge misconception around the area of structured products,” says Jonathan Fry of Premier Asset Management, which runs both conventional stock market funds and structured products. “Investors automatically think of precipice bonds, but these schemes only made up a small proportion of the overall market. The vast majority of plans truly ‘do what they say on the tin’ – provide attractive returns with complete capital protection.”
Peter Jordan, marketing director of Scottish Widows,
says demand for structured products has remained
strong, despite the fact that the firm’s parent –
Lloyds TSB – was fined £100m by the FSA in 2003 for
mis-selling the bonds. “There’s a hard core of
low-risk investors who cannot afford to lose money
and who are attracted to these products,” says
Jordan. “What we have to ensure, and perhaps did not
do as well in the past, is that they completely
understand what they are buying and that the
products are suitable for each investor.”
While some structured products do provide capital
security, experts say investors can pay a high price
for this protection. “When you buy a structured
product, you immediately lose the right to any of
the dividends you would normally get when you invest
in the stock market – that’s an immediate 3–4 per
cent reduction in your returns,” says Mark Dampier.
It’s a pretty hefty price to pay. “And what do
investors get if stock markets do nothing and remain
static?” adds Dampier. “In the bull market, we were
all conditioned to believe that share prices would,
in most years, rise. But we’ve had long periods
where stock markets have traded sideways, and there
are plenty of arguments to suggest we are in one of
those periods now. If we are, investors are unlikely
to make money out of the majority of structured
products.”
Kerry Nelson says there are six things investors
should look at before investing in any structured
product – the index it uses, the level of capital
protection, gearing, how final returns are
calculated, the level of participation in the
index’s growth, and the product term. It is
important to give investors the opportunity to make
money even if markets move sideways while still
offering a good level of capital protection.”