Structured products: the cost of a free lunch

If you want big returns, you have to take big risks. It's a basic rule of investment. So it's little wonder that many investors are drawn to structured products, whose providers claim to offer the investment holy grail apparently high returns for little risk.

There are many different products available, but they all offer a variation on a standard deal. The issuer takes your money for, say, five years. It then offers a big gain as either a "guaranteed" fixed return (60% in the case of the Lehman Brothers Enhanced Return Plan, as long as the FTSE 100 rises or stays the same), or a proportion of the gain in a nominated index (50% of FTSE 100 growth for the Britannia Guaranteed Capital Bond). Should the index fall over the period, you get your original investment back, perhaps with a small fixed return.

As these funds are under no obligation to report performance, "it's difficult to verify their claims", as Richard Saunders, CEO of the Investment Management Association (IMA), tells The Daily Telegraph. The exception is the Government's National Savings and Investments Bank, whose first five-year Guaranteed Equity Bonds (GEBs) have now matured, enabling the IMA to "conduct a little experiment".

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The IMA compared the actual return from the GEBs with the returns, after charges of 1% a year, that a basic-rate taxpayer could have expected from a standard fund tracking the same index. The GEBs "underperformed the market by about 4.5% a year". That number is suspiciously close to what analysts call the "equity risk premium". That's the additional return any investor should demand for risking their capital in shares as opposed to putting it in a risk-free cash deposit. It seems sceptics are right to question the ability of a GEB "to manufacture a return out of nowhere", whatever the advertising says.

What should an investor make of all this? First, structured products aren't worth the bother. The conditions surrounding the advertised returns are often hard to understand, and the IMA's study shows you aren't getting a free lunch. If you think stocks have further to fall, as we do, then take the full return available from something safe, such as the best cash deposit or one-year savings bond you can find (see Moneyfacts.co.uk for the latest "best buys"). Or if you really want exposure to equities but are worried about when to invest, drip feed your money in fixed amounts each month into a cheap exchange-traded fund instead. This route, as Saunders notes, gives you the benefit of "pound-cost averaging". Over the ten years from June 1998 to June 2008, you would have earned 3.7% a year on average from a UK stockmarket investment via this method. Not great, but better than the 3.4% you would have earned by dumping a lump sum in at the start.