Structured products: Weatherproofing options

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The stockmarkets, like the British weather, are somewhat unpredictable. Everyone enjoys being out in the sunshine, but if you want to avoid ever getting wet then you’re left with little choice but to stay indoors. But if you take this option, you’ll never go anywhere.

Structured products provide you with the opportunity to venture out into the markets, but carrying an umbrella just in case it rains. Consider an auto-call – if it doesn’t rain after two years, you get a fixed amount for each year you have had your umbrella and go back inside with the proceeds.

If it rains, the protection will keep you dry hopefully in time for the sun to come out again.

But just like an umbrella, protection built into structured products won’t save you from complete disaster. So if a hurricane comes along, you’re going to lose your brolly, thus your protection, and get wet along with everyone else.

Let’s put the protection offered by structured products into some context. The barrier level on most structured products linked solely to the FTSE 100 is 50 per cent. Some of the barriers are observed during the term and some only at the end.

Consider a six-year, FTSE 100-linked product with a 50 per cent end of term barrier, which strikes at a time when the FTSE 100 level is 7,000. In order to lose capital from market movements, the FTSE will need to be below 3,500 in six years time. We know that past performance is not a guide to the future, but in its history, the FTSE 100 has never fallen by more than 50 per cent over a six-year period.

Furthermore, a FTSE level of 3,500 is a long way down – the last time the index closed below this level was at the very end of the dotcom correction in 2003 and before that, not since October 1995. However, such a fall is not impossible and this is why structured, capital-at-risk products offer good potential returns for investors as the reward for this risk.

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To carry the analogy further, some structured products are made even stronger to withstand a downpour. These defensive structured products offer gains even if the underlying asset, say the FTSE 100, falls up to a pre-determined amount. For some auto-calls, a reducing reference level will be used at subsequent anniversaries, providing a bigger opportunity for the product to mature, but the returns on offer may be lower than a straightforward auto-call.

To put the protection offered by structured products into some real-life context, out of the 460 products that matured from April last year to April this year, 449 made a gain for investors, while 10 returned capital only, according to StructuredProductReview.com. One product made a loss.

Granted, the sun was shining at that time, but regardless the protection was still there and attractive returns were made by structured products. The average annualised return of capital-at-risk products was 8.37 per cent over an average term of 3.42 years, according to figures from StructuredProductReview.com. The first quartile returned an equivalent figure of 11.50 per cent, while the bottom quartile delivered 6.03 per cent.

Capital-at-risk investments would not be suitable for investors who cannot tolerate a loss but other than in a consistent, worsening torrential downpour, a structured product should at the very least return original capital, and if it’s ‘sunny’, an attractive, pre-defined return should be delivered.

As for risk averse clients who cannot tolerate any loss, there are ‘capital-protected’ structured products that may prove suitable, although these will still lose money in the event that the counterparty defaults. To offer some protection against even this, there are deposit-based products that potentially benefit from FSCS protection.

Failing that, totally risk-averse investors will be left with little choice other than to stay out of the structured product market and consider simple deposit accounts, but the risk here is loss of capital at current interest rates.

Since markets are currently at such high levels, the protection structured produtcs can offer is a sensible consideration for investment portfolios.

Key takeaway:

Structured products can offer some protection in down markets, but investors still need to be willing to risk capital and potential counterparty risk.