"Be sceptical by all means, but to dismiss a whole investment area simply because we do not understand it is far from acceptable." That's how Ian Lowes of Lowes Financial Management defended structured products recently. He suggests that many of them such as the Legal and General FTSE Growth Plan 8 are "as simple to understand as an ETF or an Oeic". I'd beg to differ. Here's why.
What are structured products?
There is no universally agreed definition. But typical features include performance that is linked to an underlying index or asset; a 'binary' payout (based on one of two possible scenarios); a fixed investment term; and high fees. The L&G FTSE Growth Plan 8 cited by Lowes is a classic example. In return for a minimum £3,000 initial investment over five years, you get one of two possible payouts when the plan ends on 16 March 2016. If on that day the FTSE 100 index closes at a level equal to, or higher than when the plan performance period starts on 16 March 2011, you get a 50% bonus based on the sum invested. So put in £3,000 at the start and you could expect to get back £4,500 less commission. So far, so good.
But if the FTSE closes at a lower level, watch out. If it falls by less than 50% of its opening level, you get your £3,000 back (less fees). However, should it fall by more than 50%, your capital suffers in the same ratio. So if the FTSE 100 is 60% lower on 16 March 2016 than on the same date in 2011, you lose 60% of the sum invested. Not so great. That said, for a cautious investor who wants a bit of exposure to the stockmarket but with limited downside risk, some brokers will argue there's still plenty to like here. Here's why I disagree.
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It's too complicated
The way the bonus payout is calculated on this product is quite simple compared to many similar products (where, for example, the FTSE may be averaged in the last year of the plan). But you need to hunt through the small print to see just how much of your initial capital you could lose if the FTSE plunges. That's not as unlikely as it may seem. The FTSE has recently traded near two-year highs, so who is to say it will close above 6,000 points in five years' time? It only has to close one point below the start level on the end date for you to lose the entire 50% bonus. Were it to fall off a cliff due to some new disaster, your capital could be hammered.
Moreover, a 50% bonus isn't as good as it sounds. While you are waiting to get it five years you will receive no dividends or interest. Instead of buying this product you could put your £3,000 into, say, the best three-year fixed-rate bond at 4.15% or, even better, the best cash fixed-term Individual Savings Account paying 4.3% (tax free). Or perhaps even the Post Office inflation-linked bond paying the Retail Price Index (RPI) plus 1.5%. So let's say you can achieve an average pre-tax rate of 5% over the next five years. Compounded, that's a low-risk return of around 28%. So the structured product bonus only adds another 22% on top and also puts your capital at risk. If you think a cash account sounds a bit dull, why not just invest in blue-chip equities, or even a FTSE 100 exchange-traded fund (ETF)? There's more risk to your capital, but in both cases you'll get dividend income as well as any capital growth over five years you won't with a structured product.
As a rule of thumb, the more complicated the product, the pricier it will be. Here the fee is 3% of the sum invested, taken up front. That's hefty a FTSE 100 ETF can be had for an annual fee of below 0.5% these days and even an actively managed investment trust won't be much more than 1%-1.5% a year.
In the current climate of rising inflation and potentially interest rates a lock-up period of five years isn't attractive. Better rates on cash accounts and bonds are likely if and when rates rise. If you try to cash in most structured products early, you'll be hit with a redemption penalty.
The hidden default risk
Most structured products are backed or sponsored by a third party. That's because the plan takes your money and invests in instruments which include derivatives on your behalf. So, for example, while Legal & General is the product manager for the FTSE Growth Plans, the underlying securities are issued by HSBC. Now, HSBC is a solid blue-chip bank with an AA credit rating from Standard and Poor's we're not saying for a moment that it'll go bust. However, it's worth remembering that the 2008 collapse of Lehman Brothers (which also had a good credit rating) affected several structured products. Worse, with some products there is a risk that should a provider go bust the Financial Services Compensation Scheme will not cover you. Santander recently wrote to customers who bought its Guaranteed Capital Plan and Guaranteed Growth Plan products between October 2008 and January 2010 to make this very point and offer a refund of the sum invested.
In summary, you are paying a great deal for your own indecision with a structured product. If you are bearish, pick a decent cash account for now. If you are bullish, choose a low-cost ETF. But don't fall between the two stools and buy a product that leaves you locked in expensive limbo.
Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.
He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.
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