Guide to Structured Products

Structured products are investment vehicles designed for investors who wish to combine the potential upside of strong stock market growth with a guarantee that they will get their original investment back.

The investor places money into an investment fund which is designed to mature at a future date - usually five to six years in the future.Most of the money provided is invested in a low risk bond, which offers a guaranteed return over the term of the structured product. Usually, the guarantee is that the original investment (the ‘capital’) is protected and will be returned to the investor at the end of the investment term

For example, if the total investment in the structured product is £100, and part of this money is invested in a bond which offers a guaranteed 20 per cent return over the life of that product, then of the £100 invested, £83.33 will be invested in the bond. When the structured product matures, the bond will be worth £100.

The difference between the amount invested in the structured product, and the amount invested into the bond is then invested into other more risky areas. In the case of this example, of the £100 initially invested, £16.66 is available for more risky bets.

Use the links below to move to the section you want to read:

• Capital protection
• Precipice bonds
• Derivatives
• Other investment types

Mitigating risk

Typically, the zero risk element of a structured product is in the form of a zero coupon bond. Such a bond pays out no dividends, but has a set redemption value instead.

How the more risky elements of the structured product are invested varies. The risk capital could be invested in hedge funds or futures contracts on an index such as the FTSE 100 or a commodity.

The problem with futures contracts is that, while they offer the potential for high returns, they entail the risk of high loss. The money set aside to cover these risky investments much be sufficient to cover the potential losses.

Using options

Options, which confer on the holder the right to buy or sell an asset at a future date, are often popular ingredients of a structured product, since the downside of these investments is built into the initial price.

So returning to the example above, a £100 structured product, with £83.33 invested into a bond, could entail a £16.66 purchase of an option. If the option is to buy a specific asset, and this asset then falls in value, then the option will not be taken up and the £16.66 initially paid out will be lost.

If on the other hand, the price of the asset goes up, the option may well be realised, and the profit will equate to the difference between the market price when the option is realised, minus the price of the option at the outset, less the amount paid for the option.

In practice, however, many structured products entail a maximum and minimum potential return. The investor then knows the best and worse possible outcomes for their investment. This is a nice ‘peace of mind’ feature, but investors should remember that guarantees cost money and that by limiting the downside, they are also limiting the potential upside.

Example of a structured product

An example of a typical structured product being sold today is the the Arc Capital & Income Bull & Bear Track Plan 2 which is being promoted by IFA firm Chartwell. This provides:

• 100 per cent of any capital growth in the FTSE 100 over a 6 year term, OR,
• a 1 per cent return for every 1 per cent the FTSE 100 falls up to a maximum of 50 per cent.

There is 100 per cent capital protection of your initial investment, if held until maturity. So at maturity, the only circumstances in which you will not make a profit on your initial investment is as follows:

• if the final value of the FTSE 100 index is exactly the same as the initial level; or
• if the FTSE 100 index falls during the 6 year term by more than 50 per cent and the final level is not above the initial level. Even if this happens, your capital is secure.

Capital protection

As an example of how this might work, on a £25,000 initial investment, if the final index level (after averaging) of the FTSE 100 index is 55 per cent higher than the initial level, you would receive your initial investment of £25,000 back, plus 55 per cent (£13,750),so that your total proceeds would be £38,750.

As an example of how this might work, on a £25,000 initial investment, if the final index level (after averaging) of the FTSE 100 index is 35 per cent lower than the initial level and has not fallen below 50 per cent of the initial level any points during the term, you would receive your initial investment of £25,000 back, plus 35 per cent (£8,750), the total proceeds returned to you will be £33,750.

Alternatively, if the FTSE 100 index were to fall during the 6 year term by more than 50 per cent, and the final level is not above the initial level, you would still receive your initial investment back at the end of the term – namely £25,000. However, investors need to remember that the return of capital guarantee only applies if you hold the investment until the end of the 6 year term.

Precipice bonds

But while the above examples describe the most common type of structured product, not all structured products are like that. A structured product is usually structured for a specific purpose. It may be structured for one investor, and designed to meet that particular investor’s objectives. Alternatively, it may be structured to meet a particular type of risk profile.

Even though structured products are meant to mitigate against potential losses, some structured products have had the opposite effect. ‘Precipice bonds,’ which were popular in the 1990s, offered investors high potential rewards by tracking certain indices, which had enjoyed strong growth. Unfortunately, when some of these indices fell by up to 80 per cent, as they did in the 2000-03 bear market, some precipice bonds left investors with catastrophic losses.

Derivatives

Structured products sometimes use derivatives to provide the guarantee.Derivatives are contracts to buy, or sell, a certain asset or commodity at a future date. Typically, when we think of derivatives, we think of the futures market.

But derivatives can also include options, swaps, warrants and bonds, plus many other less well known types of investment. Derivatives cover such a broad range of product types, that it misleading to pigeonhole them as possessing a specific characteristic. It is wrong, for example, to describe all derivatives as risky, as they can be used to mitigate against risk.

For instance, farmers saw the derivative market as a way to guarantee the price of commodities they produced, such as wheat, barley, cotton and so on. That way they knew that, even if the market price for wheat crashed, they would be able to obtain a certain price agreed in advance. So they were able to plan ahead with a degree of certainty.

In a similar way, businesses can use derivatives on units of currency. A UK-based business may, for example, enter into an agreement to buy 100 units of widgets, from a supplier based in the US at some point in the future.

The price may be fixed in US dollars, but the supplier may worry that the dollar/pound exchange rate may change, perhaps increasing the sterling price.

To mitigate against this eventuality, the producer may take out a contract to buy US dollars at the point the deal is due to be completed. But today, derivatives are often used by sophisticated investors to speculate on future movements in price. They can offer the potential for high rewards as well as huge losses, so buyer beware.

Other investment types

Futures

A ‘futures’ investment entails a contract to buy or sell an asset type at a specific price, at a specified future date.

Options

An option provides the option holder with the right, but not the obligation, to buy or sell an asset a specified future date.

Swaps

Swaps are where two parties agree to exchange cash flows. Most commonly, swaps entail a swap in interest rate flows relating to two different currencies.

Warrants

Warrants are securities that allow the holder to buy a proportionate amount of stock at a specified future date at a pre-agreed price, usually one higher than the current market price.

They are traded as securities whose price reflects the value of the underlying stock. Corporations often bundle warrants with another class of security to enhance the marketability of the other class. Warrants are like call options, but with much longer time spans, usually a few years.

Contracts for difference (CFDs)

The use of CFDs has grown rapidly since 1999, it is estimated that they make up 25 per cent of turnover in the UK stockmarket.

CFDs are leveraged equity derivative securities that allow the user to speculate on share price movements, without having to own the shares. (For more on CFDs see our Guide to Contracts for Difference).

This means that investors can trade ‘long’ or ‘short,’ and unlike other derivatives, such as futures contracts or options, there is no fixed expiry date or contract size.

ADRs

Another popular type of derivative is the American Depository Receipt (ADR). An ADR is the way in which the stock of most foreign companies trade in US stock markets.

They are issued by US depositary banks, and they represent one or more shares of a foreign stock or a fraction of a share. Investors who purchase them have the right to obtain the foreign stock it represents, but US investors usually find it more convenient to own the ADR.

The truth is that there are a number of derivative and warrant contracts available on the market. Each can be organised according to the needs of the investor, and can reflect the current economic mood. They are a great option for investors and can help secure a financial future in later years.

Last edited 18 February 2009

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