Structured products are a class of investment product created to offer a return that differs from the returns available directly from the underlying investment. They don’t necessarily take the risk out of investing, but they should be designed in a way that will help you understand easily what the likely outcomes are for your investment. If you don’t understand what the possible outcomes are for a particular product, and can’t get the answers you want, don’t buy it!

Most structured products are made up of a combination of cash and derivatives:
 
•    The cash element is usually made up of medium-term notes (MTNs). In essence, these are loans to the companies that issue them. They are designed to run for the required time and most products not issued directly by a financial institution would buy MTNs from recognised financial companies such as banks and building societies.

•    The derivative element provides exposure to the underlying stock market index. The most commonly used are put options and call options.

Call option
A call option gives its holder the right, but not the obligation, to buy something at a previously agreed price at some point in the future. So, if someone holds a call option on the FTSE 100 Index that can be exercised in five years’ time, they will be able to “buy” the index at today’s price. In other words, if the index has risen, they will be entitled to that gain, but if it has fallen, the option is worthless.

Put option
A put option gives its holder the right, but not the obligation, to sell something at a previously agreed price at some point in the future. So, if someone holds a put option on the FTSE 100 index that can be exercised in five years’ time, they will have the right to “sell” the index at today’s price. In other words, if the index has fallen, they have protected the value of their investment because they can sell it at today’s price.

How do structured products work?

There are all sorts of ways of putting together these products to generate different returns, but the basic principles are quite straightforward. They fall into two broad categories:

•    Those that offer capital protection and some stock market exposure, or “growth products”
•    Those that pay a higher income generated at the cost of some risk to the investor’s capital, or “income products”

Growth products

Growth products are made up of a combination of cash (MTNs) and call options. Enough of your investment is invested in cash so that it will grow to be worth 100 per cent or more, depending on the product. The rest of the investment goes towards charges (five to six per cent) and to buy call options. The amount spent on call options dictates the terms of the product.

Five year interest rates are currently about 5.8 per cent, so to return an investor’s capital, about 75.5 per cent of the initial investment needs to be made up of cash, leaving about 19 per cent (after charges) to buy call options. Spending this much on options will give investors 110 to 120 per cent of any rise in the FTSE index.
 
•    Minimum returns greater than 100 per cent
Recently, products offering a minimum of greater than 100 per cent of your investment have proven popular. Generating a return of 120 per cent over five years will mean that most of your investment goes into cash, leaving less to buy options. It is important that you understand what the chances of additional growth are with these products. This is particularly the case if the growth is calculated as the sum of returns over six monthly periods (or in other complicated ways), because it may be so low that you might just as well invest in a fixed-rate cash product instead.

•    Products that might mature early
Another very popular product at the moment offers a high level of participation in the underlying stock market index, but with the possibility of an early maturity if certain trigger points have been reached (for example, 30 per cent growth after three years). The product will pay a set amount back to investors (their investment plus 30 per cent in this example).

The principle is easily understood with these products:

If an early trigger point has been reached, it’s likely the index might be quite a bit higher. It is also possible that it will end the six-year period higher, so it is assumed investors will miss out on this extra growth.

However, if you’re happy with the terms for the early maturity payments, and feel that it’s better to take profits in the present rather than hope for higher returns in the future, these might be more suitable for you.

Income products

For most investors, the capital they have accumulated over their working lives goes to fund a better lifestyle in retirement, so income-generating products are always popular. Investment companies are well aware of this, and many products are designed to attract this income-seeking capital. Headline yields can, however, often mask significant risks to capital, as well as higher charges. They are typically five per cent initially plus 1.5 to two per cent per annum on most fund products, compared to five to six per cent over a five-year term on structured products.
 
Most structured products currently offer more modest income levels than they did in the past (six to eight per cent per annum) and generally work on the same principles. To generate the extra income from your investment, a product provider needs to “add” some more cash. To do this, they sell put options, and the premium received from the sale of these, together with the cash from your investment, generates the higher income and the 100 per cent return of capital. However, the sale of the put options also generates a liability. If the underlying index is lower when the options expire (at the end of the investment term), your money is used to pay the holder of the option the amount the index has fallen by.

Most income products offer “safety nets”, allowing the relevant index to fall by up to 50 per cent before capital is at risk. These offer a genuine reduction in the level of risk to your capital and work by selling a put option that is only valid if these falls have actually happened.

Diversification

Structured products can offer investors access to asset classes that are difficult and expensive to invest in. It’s quite expensive to buy a portfolio of houses, but an investment linked to the Halifax House Price Index can deliver the same benefits with a greater level of diversification and a fraction of the associated costs. Exposure to commodity prices has also proven popular in the structured product market in the past couple of years, as well as exposure to overseas equity markets.

Why might you be interested in structured products?

Although interest rates have been rising recently, many investors still aren’t able to secure the returns in the bank or building society that they would like. Some have sought higher returns from the stock market, encouraged by successive governments offering tax rebates in the form of PEPs and now ISAs, but with the FTSE 100 lower than it was eight years ago, many have been disappointed, seeing low returns or even losing money. We all know that past performance isn’t a guide to the future, and that the value of stock market investments can go down as well as up, but for many investors, financial advisers, investment pundits and assorted other experts, the past eight years have been the first time those ubiquitous warnings have actually meant anything.

The attraction of structured products isn’t that they can provide higher returns with no capital risk. However much people pretend this is possible, it isn’t. Structured products offer investors a clearly defined return – they do what they say on the box.

Clive Moore is managing director of IDaD, a specialist structured product consultancy established in 2002. IDaD specialises in the development of investment products, particularly structured products, for banks and other product providers in the UK and overseas.