Transcript: The Truth About Structured Products

Published in Investing on 16 April 2012

David Kuo talks to Ian Lowes.

You can listen to or download this podcast here.

 

David:

This is Money Talk, the weekly investing podcast from The Motley Fool.  I am David Kuo, and today we are going to look at structured products.  Now, what would you say if someone offered you a product that could provide you better returns on cash, but without the risk of investing in shares or bonds?  The marked is littered with products that give investors some exposure to financial markets, but with some downside protection, in the event of a stock market meltdown.  Now, are these products too good to be true?  Or are they really the Holy Grail of stock market investing?  Here to explain the truth about structured products is Ian Lowes from Lowes Financial Management, and CompareStructuredProducts.com.  Welcome to Money Talk, Ian.

Ian:

Hello, David.

David:

Have you come all the way down from the north today?

Ian:

From Newcastle, yes.

David:

From Newcastle – that is up north, isn't it?

Ian:

Yes!

David:

OK, so without further ado, let's have a look at structured products.  What exactly are structured products?

Ian:

Right, first of all, they are not the panacea of all investments, and they are not going to give you guaranteed returns with no risk.  Ultimately there are a lot of different investments that people confuse with structured products, and there is no set definition for what one is.

David:

Why is that? – because everybody talks about them.

Ian:

Well, a lot of people talk about them in the context of a particular investment that they consider to be a structured product.  What I consider to be a structured product is an investment that has a defined return linked to a defined underlying, such as the FTSE 100, and delivered at a defined date, so they are very defined.

David:

OK, so that is what we understand as being a structured product?

Ian:

That's my definition, yeah.

David:

OK, so why were they developed?

Ian:

They were developed some years ago as an alternative to direct equity investments, an alternative to straightforward bond investments, and an alternative to deposits.  Essentially, there's a lot of different types of structured products, and they would form a combination of all of those elements, depending on what type of structured product you're going to use.

David:

But we actually use the generic term, structured products, don't we? – to mean that you have some exposure to the stock market, but at the same time, if the stock market were to fall, you would be, well your backside would be covered?

Ian:

It doesn't have to be the stock market, and very few of them in the market cover your backside in the event of a disaster.  A lot of them will cover your backside, as you say, up to a 50% fall in the market.  After that, you might as well have been in a tracker – less dividends.  Some of them are deposit-based.  Now, the deposit-based ones do give you the potential for exposure to the upside in the market, whether it be the FTSE, the housing market or whatever it's linked to, delivered at a defined date, but in the worst case scenario, you will get your capital back, but you've sacrificed the interest that you would have earned, had you just left your money on deposit.

David:

OK, so who are the main providers of structured products?

Ian:

Ultimately, in my market, which is the independent financial advice distributed market, Barclays, Morgan Stanley, Investec, Meteor Asset Management, Walker Crips, Legal & General, Aviva ...

David:

Household names?

Ian:

They're household names, yeah.  There are many banks and building societies who will also offer structured products, which are essentially structured deposits, so most high street banks will offer them.  Now, I wouldn't suggest you go and buy your structured product, or any other investment, from a high street bank, because obviously we're independent financial advisors.

David:

So how are these products marketed to the consumer?

Ian:

Again, there are a huge range of structured products.  You have listed securities, which obviously are promoted through the London Stock Exchange; you have the IFA-distributed models, the products that are promoted through independent financial advisors; and then you have branch bank/building society sold contracts, which are promoted to people who come in to deposit money.

David:

So how do they work?  How do structured products actually work?  If I was a consumer, an investor, and I went out and bought one of these products, how does it work?

Ian:

It depends on the product, entirely on the product.  If we work on a capital-at-risk version -

David:

Capital-at-risk version?

Ian:

Yeah, we'll use a capital-at-risk version, so this is essentially an investment which is going to give you equity exposure, so stock market exposure, with some risk.  I'll give you one example – it's a five-year investment, but at the end of five years, if the FTSE's higher, it will give you a 60% gain; if it's lower, it will give you your capital back, unless the FTSE is 50% or more lower at the end of the five years, in which case you'll track that loss.  The caveat to that is if the bank behind it goes bust, you've lost your money – it's not covered by the Financial Services Compensation Scheme.

An alternative to that might be a deposit-based contract, which might give you, for example, 200% of the rise in the FTSE 100 index over five years, subject to a maximum return of 40%; capital back if the FTSE falls over the five years, and that, up to the £85,000 threshold, would be covered by the Financial Services Compensation Scheme, subject to the usual limits.

David:

OK, well you make it sound very simple, and you make it sound quite enticing at the same time, so why are you here?  What are the main problems with these structured products that you want to alert people to?

Ian:

When we started our original website, which was The Truth Behind Stock Market Bonds, that was about 12 years ago.  That was because there were a lot of these contracts which were being promoted very heavily by some of our competitors to our clients, which were offering high rates of income, say 10%, and underplaying the risk.  Now, these were not risk-free investments, and ultimately they did what they said on the tin: they would pay you a high rate of income for three years, and if the FTSE was down at the end, you would suffer a loss on your capital equivalent to the fall in the index.

David:

Why is that?

Ian:

Because that's the way they're designed.  You aren't going to get a 10% income without taking some risk.  If the bank's offering you 3%, someone's offering you 10%, something's got to give somewhere.

David:

So where has the money come from, in the first three years?  Has it actually come from your own investment, or has it actually come from genuine returns from the stock market?

Ian:

Ultimately what's happened here is that the money has been placed essentially on deposit, or loaned to the bank.  That's designed to give the capital back at the end of the three years.  There's money set aside to provide the income, but that money has been enhanced by selling an option which would give you a loss, if the market fell.  Now, rather than selling one option, which would give you a loss of 10% if the market fell by 10%, these contracts sold two options essentially, which gave you a loss of 20% if the market fell by 10%.  So these were your ultimate precipice bonds, and in some cases, because the market fell by significant amounts, some of them had sold three options essentially, so you had lost three for one.  If the market drops 33%, you've lost your capital, and there was a lot of this out.  

Now, the more risk that you take, in terms of that downside, the more upside that you're going to get in terms of something, and in this case it was the income.  But I did not feel that that 10% income was sufficient reward for the risk that you were taking, and our clients were approaching us with the literature from these plans that were being promoted to them, and we were telling them to steer clear, and ultimately we felt we had to go public a little bit more, and warn people away from them.  That didn't make them all bad at that time – there were other contracts that weren't of the same ilk, but didn't have the 10% rate – they might have had a 7% rate, because you were taking less risk.  I think that's ultimately what happened – you got a situation where you had some negativity in the market, which ultimately attracted some bad press, and rightly so, and the whole market gets tarnished.

David:

So are you locked into these products for the entire five-year period, then?

Ian:

Whatever the term is, I would always say, buy a structured product with the full investment term.  That means it should be your only investment; it should never be your only investment – it's got to form part of a portfolio.  You might have a four-year plan, a five-year plan, a six-year plan, put them all together as part of your overall portfolio of other assets, but intend to hold those for the full duration.  You can get access to them now, so you could get access mid-term, but you're not going to get the defined outcomes.  Now, in the listed space, traders are trading in and out of these contracts because they'll see it as the right opportunity to do so at the right time.  I would suggest the retail investor and most independent financial advisors are not equipped with the know-how to do that.  That sort of trading should take place within a mutual fund that's investing in structured products.

David:

But wouldn't you say that, over a five-year period, that if I were to buy a basket of shares with the intention of holding them for a five-year period, the chances are that the shares are going to be higher at the end of that five-year period than they are today? – so why would somebody want to buy a structured product, rather than to actually buy a basket of shares with the money that they're going to be putting into the stock market?

Ian:

I would also like to think that, if I buy a basket of shares, in five years' time it's going to be higher.  What I do know is, that I don't know, and ultimately we will use structured products, essentially we build a portfolio which is going to have your baskets of shares, whether they're in mutual funds, etc, so that's going to form the core of the portfolio.  But then, alongside that, if we used a structured product that will mature in five years, given certain parameters, if it returns your capital when the market is 49% down, that's a good thing.  If the market's 55% down, it's going to suffer a 55% loss.  The portfolio's going to give me the benefit.  

Now obviously, I'm sacrificing something here, so if the market goes up 100%, I might be capped at 60%.  So it's a case of changing the risk and return profile for something which complements your share portfolio, because you know that you don't know that in five years' time that portfolio of shares is going to be higher, so it's just a different type of investment.

David:

OK, so what do you say to those people, those critics of structured products, saying that it is nothing more than a cynical marketing exercise targeting vulnerable and probably ignorant investors, people who don't know what they're buying, and they just simply think, oh – if I give this bank or this building society X thousands of pounds, then at the end of five years, I'll be able to get something back from my investments?

Ian:

I've definitely seen examples of that, so I tend to agree that there are examples where these have just simply been a cynical marketing exercise which has been promoted by the bank, and ultimately they are not following an investment philosophy anybody would ordinarily follow, a contract that might look at the FTSE on every six month basis, and take an element of their gain, or the element of the loss, and add it all together, and ultimately this gets confused and concocted into something that gives you a high potential headline rate, which looks very enticing, and the chances of you getting that maximum return, you've got more chance of winning the lottery.  Now this, I think, is what the FSA are now addressing.  

In a recent paper, they were saying that you need to identify what your target market is, and what your investment is intended to do for that target market. That sort of example I've just given you there, the target market, I think, is the profit of the bank.  So there are examples that I would say, steer very well clear of.  There are a lot of other investments that I think, that when most people sit down and have a good look at them, and consider them in the context of what they are, and what the alternatives are, they will see them as a suitable complement to a portfolio.

David:

OK, so what products do you think people should be looking at?

Ian:

Let's stick to capital-at-risk.  Let's not get confused about, some of these investments are sold as a safe haven, so let's consider this as an alternative to 100% investment in mutual funds.  Let's take some of that portfolio and put it into a structured product, and let's start with a very simple, what they call a kick-out contract.  This might record the FTSE at the beginning of the investment term, so let's say we've got a maximum investment term of six years, so we're committing to a six-year term.  

If the FTSE is, say, at 5,800 points today, in a year's time, if the FTSE is above 5,800, that product will mature, it will give you your capital back, plus a 10% return, say.  Now, that 10% return is going to depend on when that contract was created.  It might be 10% today, but the same contract a year ago might only have been 7%, and a new one that's brought out in a year's time might be 11%, so these returns depend on market conditions.  

So currently, we could buy a contract which is going to give us a 10% return in a year's time, if the FTSE's higher.  If it isn't higher, it runs for two years, and if the FTSE's above 5,800, it will give you a 20% return.  If it isn't above 5,800, it runs for three years, and it adds 10% on each year until the end of the six years.  

Now, if it's run six years, it's because the FTSE's been lower on every anniversary.  If at the end of six years it's higher, it's going to give you a 60% gain, being 10% for each of the six years; if it's lower, it's going to return your capital, unless it's 50% lower, in which case you will track the loss, so if it's 60% down, you're going to lose 60% of your capital.  The caveat to that is, if the bank goes bust, you lose all your capital.

David:

Why are you not covered by the Financial Services Compensation Scheme?

Ian:

Because that's investment risk.  This is not a case of, you have effectively lent the money to a bank, in the same way that you would have done if you'd bought a corporate bond.  If you go and buy a corporate bond from BT, and BT go bust, you've lost your money.  So no financial services compensation scheme is going to compensate you for investment risk.  Now, in order to make a loss here, the FTSE's got to be lower on every anniversary for the next six years, and 50% lower at the end, or the bank's got to go bust.  These are risks – that is a risk that needs to be recognised.  Accepting that risk, you're getting a 10% return.  

An investor needs to establish and decide whether that 10% return is sufficient reward for that risk.  It's not compounded, so if it runs for the full six years, you're down potentially below 9%.  So I think, if you use that as part of your portfolio, I've got an example I personally invested in that matured last week, this was from Walker Crips (that's the stockbroker with the pedigree of 100 years, and not the tasty potato manufacturer), this matured after a year, giving me a 7% return, which was the rates that were on offer a year ago.  

Now, I was quite happy to invest in that with a view to getting that potential 7% return, because in order for me not to have got a return on that investment, the FTSE would have had to have been lower on every anniversary, and 50% lower at the end, or HSBC would have had to have gone bust.  Now, I'll take that risk.  As it happens, the FTSE had gone up 0.3% over that 12-month period.  This is not the only investment I had – it's part of a portfolio, and like the rest of my portfolio, would have benefited from dividends.  If it would have been corporate bonds and properties, I've got other structured products that are going to mature in different years.  This return falls into this tax year.  It's going to potentially utilise some of my capital gains tax allowances, and potentially it's tax-free, but I took a risk. 

First of all, I've got the six-year period – it's part of my risk; the risk that the FTSE doesn't go up, but I'm carrying that risk through the rest of my portfolio.  So I like to think about structured products, not in the context of what's sold by bank and building societies as the deposit-based stuff that might give you 200% of the rise in the market, or 100% of the rise in the market, capped at 50%.  It's a tracker without the dividends on the upside; no downside potential, as long as you hold it out for the full term, but I like to think of them as the capital-at-risk.  

Now, you can have capital-protected contracts – these are slightly more confusing in that, it looks like a deposit.  You're not going to suffer any loss from a market movement, but just like the capital-at-risk version, it's a loan to the bank, and therefore if the bank go bust,  you're going to lose all your capital, potentially.  Now, you should get a better return from these contracts in the positive market conditions than you would from a deposit, because you're taking more risk.

David:

So how can the private investor distinguish between good and bad products out there? When we first started this podcast, I was actually quite clear about what structured products were, but I'm actually a little bit more confused now than 15 minutes ago.  So how can the average consumer distinguish between what is good and what is bad out there?

Ian:

Absolutely essential point here is, if you have any doubt about the suitability of any investment for you whatsoever, go and talk to an independent financial advisor.  Now, that said -

David:

What – any of them?

Ian:

Well, a lot of them don't understand structured products so a lot of them will avoid structured products.  Structured products don't give the same levels of remuneration to an independent financial advisor as a lot of mutual funds, so sometimes you may have to pay more if you're going to be recommending structured products, and sometimes the advisor will avoid them.  But ultimately, if you've got doubts, go and seek independent financial advice. That said, we recognise that a significant number of people in the UK choose their own investments through a lot of the online websites, and a lot of the discount brokers, so there are people who are well-equipped to make assessments of whether I'm going to go into an emerging market fund, a FTSE 100 tracker or an active managed fund, etcetera.  For that type of investor, looking at structured products, they should be able to see which contracts appeal to them.  

Now, the website that we run now is CompareStructuredProducts.com, and that lists most of the contracts that are available through independent financial advisors.  So the client can have a look at that, and see which contracts, and you can compare one against the other.  So if you've got a contract which, for example, is offering you the potential for (let's just keep it simple) a 60% return at the end of five years, and it's linked to a small bank, and another one that's offering you a 70% return at the end of five years, and it's linked to HSBC, you're going to take the 70%.  It's not always as simple as that.  Now, what we do is, we identify which ones we like – that doesn't mean they're the better ones, it's just the ones that we like), so we show which ones we prefer on our website.  There are others which are potentially higher risk, which are arguably more suitable for people who want to take more risk, but they're not the sort of thing that we would utilise in a portfolio on a day-to-day basis.

David:

But it sounds to me as though there's a lot of haze around structured products.  Now is the FSA doing enough at the moment to warn people about structured products?

Ian:

The FSA intervened in 2009, because a lot of the marketing literature that was used by some of the providers, most of these are now out of the market, was deemed to be not clear, and somewhat misleading.    So following that intervention in 2009, the industry reacted very quickly to the recommendations by the FSA, and made clear what the warnings are.  The reason why there might be a lot of haze is because, far too often, we have people who talk about structured products, and have one thing in mind, and I think, as I've made clear, there is not one single thing that you could say is a structured product.   Essentially structured products are offered by national savings, occasionally, right the way through to investment banks, and including high street banks and financial advisors.  So this haze is because far too often people are generic about a structured product.

David:

Journalists as well, I take it, yeah? – journalists are actually very generic about structured products.

Ian:

Yeah, I mean I talk to a lot of journalists, and I think a lot of them do recognise that there are instances where people have walked into a bank to deposit the £20,000 that they've just inherited, and their bank has pointed them in the direction of the advisor in the corner, who's gone and tried to sell them a structured product, as opposed to putting the money into their deposit account, when it's been completely unsuitable.  Now, that is going to attract journalists' attention.  There have been a lot of examples of that.  Now that's not to dismiss all banks of doing the same thing, but that's the way it happens often in the media.  There are plenty of examples of structured products that have done very well for people.

David:

Is that just luck?

Ian:

All investment includes a degree of luck.  You can have some people who will consistently get it wrong.  So if you are desperately unlucky, just stay on deposit.  Don't be buying premium bonds – you're sacrificing your interest in return for something you're never going to get, just stay on deposit; but you do have lucky investors.  But if you diversify your portfolio, so you have got a series of different investments, you're using mutual funds, structured products form part of this in the same way that property, equity, bonds – they're essentially an asset class – then, over time, you should get a reasonable return, provided you select them properly.

Back in 2009, there was a contract that came out from Barclays, so at this point, we're in a banking crisis.  We know we're taking a degree of risk by going with anything in Barclays.  I stand by the fact that, if Barclays Bank go bust, it doesn't matter where you're invested – you're having a bad day; and this contract was going to give you a 50% return at the end of five years, provided the FTSE wasn't 50% lower at the end.  So even if the FTSE had fallen by 49.9%, you're going to get a 50% gain.  

Now, I took this contract to one of the senior cynics, in terms of structured products, and pointed it out to them, and ultimately, in their words, "it didn't endear itself to them at all."  Now, it did endear itself to us, and it endeared itself to our clients, and unless we see the market dropping to 2,800 points, or 2,400 points, as it is, at the end of that five-year period, that contract will return a 50% gain.  Now I accept, had I gone into active managed funds or tracker funds, or anything else, and the market's gone up 100%, I could be disappointed with my 50% gain.

David:

Correct.

Ian:

But if I'm disappointed with a 50% gain at the time when I'm investing back then, as part of a portfolio, I'm going to slap my wrists.  There's nothing wrong – I took the risk at the time, giving all the information that I had at the time, and I was prepared to accept that, over five years, I'm going to get a 50% gain, and if I use that so that I know that, in five years' time, on a particular day, it's going to mature, I can also use that as part of my capital gains tax planning strategy, because I know what my maximum return will be from that plan, in what tax year, and so if I invest, let's just say £20,000, my return's going to be £10,000, it should fall within my capital gains tax allowance, and ultimately it should be tax-free.

David:

OK, my final question, Ian, is – what is your overall opinion about structured products?

Ian:

They're not all good, but a lot of them offer a good opportunity to change your investment risk profile for an element of your portfolio, but use them as part of an overall portfolio.

David:

And what are you sacrificing when you actually do take out a structured product?

Ian:

Sacrificing? – you are taking a fixed-term view, so even that six-year investment that might mature after a year, you've got to take that six-year view.  Yes, you could get access to it at any other time, but don't invest in it unless you're intending to hold it for the full term.  You're ultimately sacrificing the dividends that you might have got – we're talking about FTSE 100 contracts here, so you're ultimately sacrificing the dividends that you would have got, had you invested in the market, and you are ultimately taking on the credit risk, being the bank's credit risk, and I'm assuming it's not a deposit.  But in return for that sacrifice, and the acceptance of that credit risk, you are getting defined outcomes at defined dates, in defined circumstances.

David:

OK, well that's wonderful.  I think I understand structured products now, Ian.

Ian:

Oh, I wouldn't go that far!  I could go on for hours.

David:

OK, now I have one more chore to perform, Ian, before we end, and that is to find a quotation to sum up today's podcast, and I'm sure you're waiting with bated breath at the moment for this quotation.  It comes from Confucius, who said: "Life is really simple, but we insist on making it complicated" – Confucius. 

Ian:

I agree.

David:

Thank you very much.  Now, if Confucius was around today, he'd probably have said, "Investing is really simple, but we insist on making it complicated."  So, thank you very much for coming in today, Ian.  It has been a pleasure talking to you.

Ian:

Thank you.

David:

This has been Money Talk, I have been David Kuo, and my guest has been Ian Lowe of Lowes from Lowes Financial Management and CompareStructuredProducts.com.  If you have a comment about today's show, please post it on the Money Talk web page, which you can find at fool.co.uk/podcast, and remember you can now follow us on  Twitter, @TheMotleyFoolUK.  Until next week, happy investing!

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

mcturra2000 16 Apr 2012 , 4:11pm

tl;dr.

Structured products = complicated. Complicated = rubbish.

AidanT123 17 Apr 2012 , 11:57am

I feel that the above comment is a little too simplistic in its conclusions.

Structured products are quite straightforward contracts and importantly, if you invest in one you know what the outcome will be.

Taking the Barclays product spoken about in the transcript above, you know that in five years:
1. If the FTSE 100 is at the same level or higher than when the investment started you get your capital back plus 50% gain (i.e. a 0% rise in the index over 5 years will still deliver 50% gain)
2. If the FTSE 100 is lower but has fallen less than 50% - you get your capital back
3. Only if the index has fallen more than 50% do you lose capital – 1% for every 1% fall in the index (same as a tracker fund).
4. If Barclays goes bust you could lose your capital.

That’s it – not a complicated scenario, I would suggest.

mcturra2000 18 Apr 2012 , 1:52pm

Barclays can't magic gains out of thin air. There must be a hidden risk, or a hidden cost. Why not just invest whatever proportion you're prepared to put at risk directly? No need for structured products.

ANuvver 18 Apr 2012 , 9:30pm

Interesting chat, thanks.

Your interviewee seemed to constantly resort to the refrain "oh well, they're all very different", which while technically right wasn't very helpful.

I'm sure it's a legit business and all, but I can't help being put in mind of the long con with this kind of product. And of course, most long cons start off legit.

AidanT123 20 Apr 2012 , 5:58pm

The problem with investing directly is that you are exposed directly to the market losses. What I like about these products is that they set out what I’ll get and when I’ll get it and they can protect my money in all but the most extreme market conditions. I know exactly where I stand and the way stockmarkets have been since 2008/2009 I find that is quite a valuable tool and helps balance my overall portfolio.

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