A structured product is a pre-packaged investment strategy based on an underlying index and a derivative. There are many types and no standardisation, which means they are complex. To help you decide if structured products belong in your portfolio, here is an overview.
If you are thinking about investing in a structured product offering your first questions should be:
- How does it work?
- What are the risks?
- Am I protected by a financial compensation scheme if things go wrong?
You need comprehensive answers to these questions – and should be able to find them in product literature. It’s best to ask more questions if something isn’t clear.
Structured products have grown in popularity in the UK but have been a regular for investors on the continent for years.
They are used as a complement to other investments in a portfolio and/or as a defensive investment strategy, as they have the potential to pick up gains in either bear (when the stock market is down) or bull (when the stock market is up) market conditions.
What’s inside a structured product?
They are an investment of a fixed term backed by counterparty (or counterparties) with a payout that is defined based on an underlying measurement (of an asset such as shares or a stock market index – often the FTSE 100 or a foreign index).
No matter how you cut it, structured products are riskier investments but the risk to your capital is compensated for by a potential for a much higher rate of return.
How much gain will be defined, but whether or not you receive that gain is tied to how well the underlying asset (usually a stock market index) performs.
These plans are structured like loans to a bank or other financial institution using zero-coupon bond and derivative package, often an option.
Zero-coupon bonds pay no interest during the term of the bond but return the original capital at maturity. An option is the right to buy ‘call’ or sell ‘put’ a set quantity of an asset at a given price on a specified date in the future.
Getting your money back plus the promised return depends on the issuing institution remaining financially solvent.
Counterparty risk needs to be considered for structured investment type products because, unlike structured deposit plans, there is no compensatory scheme if the institution is unable to meet its obligations. You can lose your investment.
Products are meant for holding until maturity. However, it is possible to sell your structured product during the term but with the caveat that you may not recoup your initial investment.
The risks to capital
Structured deposits benefit from protection from the Financial Services Compensation Scheme (FSCS) up to a maximum amount.
Providers will use a third party and counterparty risk must be taken into account. Putting your money into capital ‘protected’ and capital at risk products are, in effect, providing loans to a financial institution known as a ‘counterparty’.
Rating agencies can provide some insight into the creditworthiness of the counterparty.
Investing the deposit
In order to protect the capital and generate its return, the provider will invest the deposit from the investor into a complex financial instrument, such as a derivative. Derivatives are usually linked to other assets such as bonds, mortgages, other loans or an index.
The provider will also purchase a bond issued by a third party (or parties). If the third party were to become insolvent, the investor could lose some or all of their capital.
Fees, charges and commissions by the provider can also mean you get back less than you put in, so be clear about what they are before you invest.
Products tend to fall into three categories:
American or European barriers
For capital investment or capital at risk products you should become familiar with barrier protection. This feature is often built into these products and offers a degree of protection to your capital in most cases but for extreme adverse market conditions.
It means your money will be returned at maturity provided the underlying asset does not drop below a pre-determined level.
Don’t forget the counterparty risk that is inherent in these types of structured investment plans. Protection is still dependent on the solvency of the issuing institution.
Reaching the level
If the level is reached during the term of the product then you are facing a risk that your capital will be reduced if the index underlying it finishes below its initial level.
Barriers can be observed daily (American) during the investment term or on the maturity date (European). The type of barrier used has important implications, as the American barrier has the potential for daily breach the payoff will be much higher than the European barrier.
- European or End of term only: The goal is to return the original capital at maturity by specifying that, so long as the index is not below the initial level by a set percentage, the original deposit is returned. If it falls below that level at maturity then capital is generally reduced on a 1:1 percent basis.
- American or Full Term Intra Day: As with the European barrier, the aim is still to return the original capital at maturity but if the underlying index falls below the initial level (set at the start of the plan) by more than the specified percentage at any time during the investment term then the barrier is said to be breach. However, you may still produce a gain if it recovers to the initial level by maturity. If it fails to recover, the final index measure will determine the level of reduction of your capital. The terms and conditions will outline how many times a breach can occur.
- ‘Full Term Close of Business’: the closing daily level of the index for the full product term rather than any point within the term.
A structured product by any other name
Issuers such as banks, building societies or insurance companies will offer varied and numerous structured products sold under different names.
Structured products offer in three general plans: income, growth or kick out based on the market falling to a stated level and that other various criteria outlined in the product brochure are met.
- Growth: Designed to provide growth over a set period of time typically ranging from 3-6 years or geared participation. Gearing is about the leverage and exposure the structured product has to the movements of the underlying stock index. A product with geared participation will ensure a gain equal to a multiple of any rise in the underlying index during the term. A product with a 100% gearing would generate a return equal to any rise on the index. If the index rose 55% the return would be 55% return for the product. Participation in an index is often capped at a maximum return and some offer a minimum.
- Income: Designed to generate income payable (gross or net) either monthly, quarterly or annually. Either income can be conditional which means payable only if certain criteria of the underlying asset are met or unconditional where irrespective of the performance of underlying assets the income is paid.
- Autocall/Kick out: This investment product is defined by the potential to end early before it comes to maturity. The payout will be based on the behaviour of the underlying index. It is usually a set amount on dates specified in the product terms. If the index is at or above its initial level one year after the start date the plan would mature and the capital returned along with the cumulative return. However, if one year after the start of the plan these criteria are not met the plan continues until the earlier of the trigger occurring or the plan maturing.