Four reasons to avoid structured products

What's next for shares? They've seen a blistering run since the low of last March. But these gains remain under the constant threat of being wiped out if stimulus measures are withdrawn or a double-dip recession takes hold. With two major crashes in the past decade, investors are understandably concerned about risking their cash in equities. Enter the structured product. Indeed, enter a raft of them, with Legal & General (L&G), Morgan Stanley and Merchant Capital just some of the providers behind recent issues. These products promise to give you at least some of the upside if markets rise, while protecting your capital if they fall. So they seem to offer investors the best of both worlds. But, as is always the case when something sounds too good to be true, there's a catch. We'd avoid them. Here's why.

Structured products are complicated

The concept behind structured products is simple enough. But the products themselves will have you reaching for "a large G&T and a cold flannel", as Danny Cox at Hargreaves Lansdown puts it.

Take L&G's FTSE Growth Plan Three, launched this month. You have to put your money in by 30 April. In return, you get it all back, plus a 57.5% bonus, if at the maturity date (19 November 2015) the FTSE 100 is at, or higher than, its closing level on 19 May 2010. If on maturity the FTSE 100 is lower than this initial level, but by less than 50%, then you get your money back but no bonus. And should the FTSE fall by more than 50% below its initial level, you lose 1% of your money for every 1% the FTSE has fallen below its starting level.

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That's quite a few conditions to get your head around and this is one of the simpler structured products. So what's under the bonnet?

How they work

Let's say I'm a structured-product provider. I manage to raise £50,000 from a small pool of investors. I use 90% to buy a five-year discounted bond for £45,000. This will redeem at its face (or 'par') value of £50,000 at the point when I am committed to return capital to investors. The remaining 10%, or £5,000, I use to buy call options on the FTSE 100. Since I am not offering 100% of the gain on the FTSE 100 to my investors (nor any dividends or interest, as we'll see below), I should be able to pay out a fixed proportion of the rise in the index and still make some money when and if I cash in these options.

Issuers tend not to reveal exactly how each product is structured. But even if they did, Cox concludes, most investors "will never understand what they are entering into". That's not their fault these things can be a nightmare to fathom. And complexity isn't the only problem we have with structured products.

Why they are so risky

Earlier this year, Tenon Financial Services became the first financial services firm to be fined by the Financial Services Authority (FSA) for failing to advise clients of the risks of structured products. In this case, the key risk that customers hadn't understood was that products backed by Lehman Brothers would be worthless should the bank go bust.

That may have seemed unlikely at the time, but Lehman did indeed go bust in September 2008. Between them, 5,600 people are thought to have lost £107m, according to the FSA. It also noted that 425 structured products sold between November 2007 and August 2008 netted Tenon £268,000 in commission. That's why some advisers love them. The L&G product mentioned earlier also pays a healthy commission to advisers up to 3% of the amount invested.

L&G's product is backed by securities issued by HSBC and rated AA by ratings agency Standard and Poor's. Sounds safe enough. But Lehman had a similar rating. While we're not saying that HSBC is at risk of going bust, this dependence on a counterparty does add another layer of risk and complexity to structured products.

Lost dividends and interest

Most structured products investing in equities (as most do) ask you to sacrifice both dividends and the interest available had you put your money in the bank instead. That's costly. Over the last five years the return on the FTSE without dividends was just 7.8% it was more than three times that with them. As for interest, a three-year bond from Nationwide Building Society will pay you around 4.6% a year. Buy a structured product and you sacrifice the chance of earning either.

Going down with a sinking ship

The other major problem with these plans is that they don't let you out until the end of the plan term, or if they do, you get hit with big redemption penalties. We don't like this inflexibility. For example, should the stockmarket plunge, you want to be able to get out of stocks and into something safer. But stuck in the L&G product all you can do is sit and watch as the FTSE heads down towards the 50% barrier, where your capital starts to be eroded. As Brian Dennehy of independent financial adviser Dennehy Weller concludes: "In the current climate I wouldn't want to be in illiquid investments."

What to do

With the latest batch of structured products it seems investors are paying a very high price for indecision. If you think the FTSE will rise, just track it with a cheap exchange-traded fund (most charge 0.5% or less in fees), or buy some decent blue-chip stocks. And if you think it will fall, park your cash in a savings account, or some National Savings and Investment tax-free certificates. If you really are confused then put, say, 80% of your money somewhere safe and take a risk with the rest. This way, if your view turns out to be overly optimistic or pessimistic and you want to switch later, you can.