HomeCombine historically low interest rates and volatile equity markets and you have a pretty challenging set of circumstances for investors. This may explain the rise in sales of Structured Products which purport to offer access to equity style returns but with capital guarantees.
But how do these products work? What are the risks? Are they right for you? Where do you find value for money products?
In this article we take a detailed look at Structured Products and over coming months we will be focusing on some of the providers of such plans.
Structured Products are undeniably different to more traditional types of investment and can be more complex. However, for the right investor, in possession of all the facts, they can offer attractive returns with a high degree of capital protection.
Types
There are essentially two types of Structured Products available:
- Investment based
- Deposit based
Investment based: A Structured Investment Product is a legally binding contract between an investor and a bank. The investor lends money to the bank for the term of the product. At the end of the term, the investor receives the product return from the bank plus a return of capital, providing certain criteria have been met.
The product return is based on a formula, sometimes based on the performance of the prices of individual shares, but more typically on a share price index, such as the FTSE 100.
The product is issued in association with a third party, known as a ‘counterparty’ who provide the returns and the guarantees. If this third party goes bankrupt, you could lose some or all of your money, even if a product is labelled as ‘protected’ or ‘guaranteed’.
Deposit based: Deposit based plans are similar to Structured Investment Products except that, instead of lending money to the bank, the investor deposits money in the bank.
Structured Deposits are always designed to return at least the initial amount deposited at the end of the product life.
Depositors benefit from extra protection over lenders; in particular, UK investors in Structured Deposits, subject to certain limits, may benefit from the Financial Services Compensation Scheme’s (FSCS) deposit insurance scheme. This is a key difference between Investment based and Deposit based Structured Products.
What are the main features?
Structured Products can provide investors with features that cannot be achieved through “standard” investments such as shares or bonds. For example, some Structured Products provide protection against drops in share prices; some deliver returns that increase faster than share prices themselves; and some can provide positive returns even if share prices do not increase at all.
Product returns are usually clearly defined and quoted net of all fees and charges. This means that “what you see is what you get”, although returns are generally quoted gross and could be subject to income or capital gains tax.
However, because all fees and charges are already built into the product, you cannot explicitly see what they are.
Structured Products are often used as part of a wider investment portfolio. In combination with “standard” investments, Structured Products can make a portfolio’s returns better match your needs, for example, by potentially reducing your exposure to negative returns.
How can I invest in a Structured Product?
Deposit based Structured Products can be held in Cash ISAs and will generally allow a transfer in of existing Cash ISAs.
Both deposit and investment based Structured Products can be held directly or via a SIPP (Self Invested Pension Scheme).
Companies and trusts can also hold Structured Products.
The taxation of the returns depend on how the Structured Product is held. To maximise returns, it is therefore vital that a Structured Product is held in the most tax efficient way possible.
How long do I have to invest for?
Structured Products generally have a term of between three and six years, although there are plans available with shorter and longer terms.
You should be confident that you can remain invested for the full term of the plan. If you need to access your money early there are often penalties and capital guarantees are unlikely to apply.
How do they work?
Structured products offer returns based on the performance of underlying investments, many products are linked to a stock market index such as the FTSE 100.
A typical structured product will have two underlying investment components:
A note – (a type of debt security). This component is used to provide capital protection. It may pay interest at a specified rate and interval, and may repay some or all of your original money at maturity; and
A derivative – (a financial instrument linked to the value of something else, such as a stock market index). This component is used to provide the potential growth element that you could get at maturity.
The objective of combining the note and derivative is to provide the owner of the Structured Product with capital guarantees and a positive return in the form of interest; if certain criteria with regard to the underlying index are met.
How is your capital protected?
Structured products offer two broad types of capital protection.
Full, offered by Deposit based plans – described as ‘100% capital protection’, ‘capital security’ or a ‘capital guarantee’. This aims to return all the original money invested at the end of its term, regardless of any fall in index level or asset price.
Remember though, that the cost of offering this protection will affect the returns you get, and there is still a chance you could lose some or all of your original money. For example if the bank who issued the plan goes bankrupt and the FSCS does not cover the bank in question.
Partial, offered by Investment based plans – often referred to as ‘structured capital-at-risk products’ (known as ‘SCARPs’). This aims to return the original money invested at the end of the term unless the index or asset price to which the product is linked has fallen below a predetermined threshold. If this happens then you can lose money, and with some products, quickly lose a lot or even all of your investment.
What is my return based on?
The return you receive is usually based on the performance of an index, often the FTSE 100, although plans do sometimes base their returns on a basket of shares.
Deposit and Investment based Structured Products generally pay their returns on one of three ways:
1. Kick out plans – these run for a period of time, generally five or six years but have the potential to mature early, or ‘kick out’, if an index has risen at a certain date or dates, usually the plan anniversary. If the index has risen and the plan ‘kicks out’ the plan will come to an end and the capital is repaid along with interest for each year that the plan has been held
2. Defined return plans – these provide a ‘defined return’ if certain conditions are met. For example if at the end of the plan term a specified index has risen then capital will be repaid plus a pre defined interest payment
3. Variable return plans – these type of plans provide a return linked to the total return of a specified index or basket of shares over the term of the plan. Sometimes these returns are ‘geared’ for example a plan may provide a return of 200% of the rise in the FTSE 100 over the term of the plan with a specified cap, perhaps 50%.
How is the plan taxed?
How your return is taxed is key to maximising the effectiveness of a Structured Product.
If you hold a Structured Product via an ISA, whether it be as a result of a new subscription or a transfer of an existing ISA the return you receive will be tax free. The return is also tax free if you hold the Structured Product via a SIPP.
Deposit based Structured Products not held in an ISA or SIPP are generally subject to Income Tax, whereas Investment based Structured Products are more likely to be taxed as Capital Gains. These are only rules of thumb though making it vital to consider your tax position when buying a Structured Product.
What are the key risks?
As with any investment you should understand the key risks before you invest, some of which are as follows for structured products:
Credit risk – When considering an Investment based Structured Product it may marketed by a ‘plan manager’, but the returns and guarantees are generally provided by a third party, known as a ‘counterparty’. If that counterparty goes bankrupt, you could lose some or all of your money, even if a product is labelled as ‘protected’ or ‘guaranteed’. You may not be covered by the FSCS if this happens. A Deposit based plan does not generally have a counterparty, as this role is take on by the issuing bank, however the credit worthiness or strength of the issuing bank is still important, even if coverage may be available from FSCS.
Market or investment risk – If the return of your original investment depends on the performance of a stock market index or asset and the plan you are invested in offers only partial protection then if the level of that index or asset falls during the term of the investment you may lose some or all of your original money. This risk is not present with a Deposit based plan as these generally offer full protection in the event that an index falls.
Liquidity risk – The benefits offered, such as capital protection, are usually only available if the product is held for the full term. It may be difficult or expensive to access your money before the end of the investment term. Should you need to do so, it is unlikely that you will receive back the full value of your initial investment.
No dividend income – Even if a product is linked to the performance of a stock market index, you will not receive any dividend income from the companies which make up that index. This can mean that returns are lower than on other stock-market-linked investments.
Capped returns – Many products restrict or cap the level of the return you can receive, so if an index or asset price rises above the level of that cap, you do not receive additional returns.
Averaging – The return offered by some products can depend on several measurements of index levels or asset prices during the life of the investment. While this can protect you from short-term falls in an index level or asset value, it may also prevent full exposure to any gains.
Inflation – If at the end of the term you simply receive the value of your capital back and no interest it is highly likely that the effects of inflation will have reduced the buying power of that capital sum. Furthermore if the return you receive net of tax is lower than inflation over the term of the plan you will again have not made a ‘real’ gain, this is of course the same with any investment.
So, is a Structured Product right for me?
It is clear that as part of a diversified portfolio Structured Products can potentially reduce risk whist offering the possibility of attractive returns. However, as with any investments there are always down sides and risks.
The main benefits of Structured Products can be summarised as follows:
Protection – Structured Deposits are designed with the aim of returning at least your initial investment, regardless of share prices. That protection normally only applies at the end of the product life and assuming the bank issuing the product is still trading
Investors in Deposit based Structured Products may benefit from the protection of the FSCS, this is not generally the case with Investment based Structured Products.
Access to equities – The returns offered by Structured Products are generally linked to the performance of a stock market, often the FTSE 100. You will therefore benefit from equity type returns with additional capital protection. Remember though, the returns are often capped and may be more or less that than the return of the actual index.
Gearing – Some products are designed with the aim of creating returns that increase faster than share prices themselves.
Income – Some products are designed with the aim of generating income but normally either your initial investment, or the income itself, is at risk to the share prices performing badly.
Tax efficiency – If held in an ISA or SIPP the returns on a Structured Product are not subject to tax, this can be extremely advantageous. Furthermore if care is taken about how they are arranged even plans that are subject to Income or Capital Gains tax can be attractive.
The main disadvantages of Structured Products can be summarised as follows:
Risk of Loss – In some Investment based Structured Investment Products you also risk losing some or all of your capital
Capped returns – Many products have an upper limit on the maximum possible return. This means that if share prices perform very well, or if there is a significant amount of inflation, your investment returns may not be so attractive and you could lose money in real terms.
No Dividends – As stated previously, Structured Products typically do not pay dividends.
Access – If you need access to your investment before the end of the term you may be able to do so. However, there are often penalties and you are very likely to receive back less than you invested.
Advice
Independent financial advice from a suitably qualified and experienced IFA is vital when considering a Structured Product.
It is important that you consider not only whether a Structured Product is right for you and your own unique financial circumstances but also whether which product or range of products are the most appropriate for you.
As with any investment, for the right person at the right time Structured Products can offer positive returns with a high degree of capital protection, but for the wrong investor, buying the wrong plan at the wrong time, the results can be disappointing.
Finally, review your circumstances, take advice, review the market and make a decision whether or not to invest when in possession of all the facts.
