Two-and-a-half years since the collapse of Lehman Brothers and structured products are still making the headlines.

An ugly spat between two trade bodies was recently played out in the media about the dangers of structured products. In the ‘against’ camp the Investment Management Association claimed that tracker funds nearly always outperform guaranteed equity bonds (GEBs – a type of structured product), and warned that ‘alluring marketing claims conceal high costs, hidden risks and uncertain returns’ within structured products.

The ‘for’ machine quickly swung into action with the UK Structured Products Association (UK SPA) blasting that it was ‘not a fair comparison’ and the IMA’s claims were ‘potentially very misleading’.

Are they safe?

The Financial Services Authority also warned on the marketing of structured products earlier this year, and is conducting a review into the ‘design and development’ of structured products, with a report due to be published later this year.

These sorts of discussions in the public arena make for interesting journalism, but who’s in the right here, and in light of the FSA’s concerns over these products, are they safe?

Structured products come in many guises. They are often touted as a savings product but are actually linked to how a stock market performs over a given period. They can offer income and capital growth or a combination of both. Some structured products offer full capital protection, but others offer partial or no capital protection.

As they are fixed-term products, there are often big penalties for taking out the money early.

With the GEBs that the IMA highlighted, these are a fairly straightforward product from National Savings & Investments. They come with a 100 per cent capital guarantee, backed by the UK government. The last one was issued in October 2009. It had a potential return linked to the FTSE 100, up to a maximum of 50 per cent over the five-year term. 

For example, if the index end level is 20 per cent greater than the index start level at the end of the five-year term, £10,000 invested would earn a gross return of £2,000 at the end of the term. If the index end level was 55 per cent greater, £10,000 invested would earn £5,000, because the maximum return is 50 per cent. If the FTSE 100 end level is the same as or lower than the start level, investors’ initial capital will be returned in full.

As GEBs are backed by the Treasury and capital is guaranteed, they have been popular among investors. However, NS&I currently has no plans to launch any more. 

There are also partial (or soft) protected products. This means that an investor may not get all of their money back if the index drops below a certain level, such as 40 or 50 per cent.

Structured products work by using two underlying components: a note (a debt security) and a derivative (an instrument linked to the value of something else, such as a stock market or the price of oil). The note provides capital protection, paying interest and repaying the money at maturity as needed. The derivative provides the potential growth element as required, and is often provided by investment banks (known as the ‘counterparty’). 

Structured product providers include Citi, Credit Suisse, Morgan Stanley and Santander. They are surprisingly easy to buy. High-street banks and building societies provide them, as do execution-only advisers, such as Baronworth Investment Services. 

There is also a dedicated website for comparing and buying structured products – comparestructuredproducts.com – that is run by Lowes Financial Management.

Some of the negative press is overblown. For example, the IMA’s criticism of structured products was rather unfounded. The research only covered low-risk, low-return government-backed structured products, of which there have been no new ones issued for more than 18 months. And bashing structured products for having ‘uncertain returns’ seems perverse. Surely no one can predict where the Footsie will be in six years time, so therefore no one can predict the returns from tracker funds either.

However, it’s still hard to find a financial adviser that has anything nice to say about structured products. 

Martin Bamford, managing director of Informed Choice, says although he considers the products when speaking to clients, he hasn’t recommended any yet. ‘We have major concerns about their lack of transparency, complicated small print and counterparty risk,’ he comments.

Jason Butler, director at Bloomsbury Financial Planning, agrees that structured products lack transparency, and says they are expensive too. ‘It is in the issuer’s interests to make the product as complex as possible so that it is hard for investors and fee-only advisers to quantify the costs and the profits accruing to the issuing bank.’

He adds: ‘The banks, especially private banks, love to sell these products. That should tell investors all they need to know.’

The costs are rather mysterious, as providers advertise the returns net of fees. James Harrington, chairman of UK SPA, says fees tend to be around 4 to 5 per cent, including commission, although the trade body has not done any research on fees levied by its members.

‘Four or five years ago there was confusion over structured products’ fees. But it’s an old argument as fees are very clear in the brochures now,’ he says.

That doesn’t seem to be the case though. In the brochure for one of Morgan Stanley’s structured products, under ‘What are the charges/expenses I will incur?’ it says: ‘There are no explicit initial or ongoing charges you will need to pay, except a one-off £100 plus VAT charge if you wish to transfer your plan to another plan manager. All other charges are taken into account in setting the terms offered, and the returns shown are net of all charges and expenses.’

This may be accurate as the investor won’t notice any fees being taken off them, but there is still no admission about what charges are deducted by Morgan Stanley. Barclays gave a similar response about its Growthbuilder product, saying there were no initial charges or ongoing fees. It then admitted that costs are built into the product and they don’t normally exceed 4.5 per cent of the original investment.

It’s these sorts of statements that give structured products a bad name, as providers make it look like they are free, when they are anything but.

Ambiguity

Transparency is another concern for many financial advisers. ‘They are becoming a little more transparent in light of the fallout from the collapse of Lehman Brothers and others, but remain one of the most opaque investment vehicles in the market,’ says Bamford.

Jargon-laden literature, sometimes with ambiguous wording; brochures that run to 30 pages or more; and long-winded names that talk of defensive strategies, guarantees and protection often put advisers off. 

It can also be confusing to calculate the start and end level of the index, for example, the start level can be averaged over the first five days of the investment term, while the end level might be averaged over the final six months.

Marcus Carlton, executive director of HFM Columbus Wealth Management, says although he does consider structured products he hasn’t recommended any for a while. He says the products need to be straightforward with clear information, and that counterparty risk is a big issue.

Indeed, counterparty risk frequently gets advisers riled. If a counterparty collapses it is unlikely the Financial Services Compensation Scheme will cover any losses. A spokeswoman from the FSCS comments: ‘It is unlikely, except for mis-selling or fraud by the distributor, that the FSCS would protect consumers in the event that the counterparty has gone bust unless there is a direct legal liability owed by that counterparty to the investor.’

Counterparty risk

Of course, providers argue that it’s unlikely a counterparty will fail, but seeing as the mighty Lehmans fell in 2008 and Royal Bank of Scotland came close to collapsing, it’s not impossible.

Butler points out that Lehman Brothers backed $900 million (£947 million) of structured products in 2008, before filing for bankruptcy in September of that year. As a result, some of its investors who backed structured products are expecting to recover only 20 per cent of their investment.

Admittedly structured product providers have become better at revealing who the counterparty is, and what the risks are.

Harrington argues that exchange traded funds also come with counterparty risk. ‘We get it in the neck about counterparty risk, whereas ETFs don’t,’ he says.

Some structured products are actually structured deposits, and these are normally covered by the FSCS.

For example, while Morgan Stanley is the counterparty on most of its products, it also offers structured deposits that use Lloyds as the deposit taker. In addition, it offers gilt-backed structured products, so these are safer. 

Sophie Barnett, vice president at Morgan Stanley, says that for their soft-protected products, it is very unlikely that investors would lose all their capital. ‘Every product we launch we back-test right back to the inception of the Footsie. Our soft-protected products offer full protection provided the index doesn’t fall by 50 per cent or more. And according to our testing, over a six-year horizon the Footsie has never fallen 50 per cent.’

The way Morgan Stanley’s products work, and many others too, is that if the index has fallen 50 per cent at maturity, investors lose half of their initial capital. If the index has fallen 75 per cent, they lose 75 per cent of their money, and so on.

However, it is difficult for investors to make meaningful comparisons of structured products as maturity values are not routinely published. The IMA is currently calling for this to happen.

So what is the structured product industry doing to clean up its image? Barnett says it’s a question of engaging with financial advisers and providing all the facts and information. Harrington says UK SPA already has a code of conduct for its members but wants to widen it so it’s ‘best practice’. ‘There are lots of compliance departments in our members, as a lot of them are investment banks, so it will be difficult to draw up the rules. However, some members may have to leave [the association] if they don’t agree [with the rules].’

Clearly, structured products aren’t as toxic and dangerous as some critics say. There have been improvements since the fallout from Lehmans, and the industry says it wants to improve further.

But there are still concerns around the disclosure of fees (and how expensive they are), counterparty risk, and the ease of comparing them.

In addition, advisers say there are better alternatives. Butler says low-cost multi-asset class, passive, liquid investment portfolios are better for the long term, while cash is better for the short term. He also says that NS&I’s index-linked savings certificates are good for short timeframes, and are currently back on sale now.

 In terms of what sort of investor structured products are suitable for, Butler concludes: ‘Probably a small number of short-term investors who can take the time and effort to do due diligence and like the pay-off profile compared to cash.’

The secondary market

Although structured products are a fixed-term investment, investors can sell their product early on a secondary market.

During the lifetime of a structured product, the value may at times be higher than the purchase price. So a £100 investment may be worth £110 at one point, and an investor may decide to cash it in and take the profit rather than waiting until maturity.

James Harrington, chairman of UK SPA, explains: ‘All retail products have a market maker and once or twice a month they will allow buybacks. Most structured products are also listed on the London Stock Exchange so they can be traded through a stockbroker.’ He says there are around 450 structured products on the LSE. 

However, Harrington adds that the retail market for structured products is not particularly active in the UK, as many of our structured products have capital protection, unlike many products in Europe.