Ian Lowes, Managing Director of Lowes Financial Management and founder of StructuredProductReview.com.
March 2010

Structured Education Like everyone else, I have absolutely no idea what the best performing investments will be in the future. Many will do very well, others will not. Our role as financial advisers is to try to guide our clients towards safe profits and that usually means identifying a range of investments that we believe will collectively produce reasonable returns, whilst not exposing the invested capital to undue risk. Whilst experience plays an important part in the process, common sense and understanding are the essential components.

Whilst I agree with the sentiment that if you don’t understand something you should steer clear of it, as Independent Financial Advisers surely our role is to ensure we do understand, otherwise how can we possibly give best advice?

Although the majority of our investment business is in mutual funds, it’s no secret that we’re passionate about structured products. We made it our business to understand them and, whilst we were vociferously critical of many of them in the early part of the last decade, we have been using structures in our client portfolios for over 15 years because we recognise that many represent good value and, indeed, they have served our clients well.

When it comes to structured products, I often hear that advisers either love them or hate them, but far too often it transpires that those who hate them simply do not have the requisite knowledge to make such a judgement.

No investment is free of risk, but the sector has now evolved to the point where the risks are very transparent.

An example of a recent plan that we used in client portfolios offered the potential to achieve a 60% gain after five and a half years. Obviously, this does not come without a degree of risk, the first being that the plan is designed to be held for the full term and if an investor needs to access their investment early they could suffer a loss, although they could also realise a gain. The next risk is that the investment is, in effect, a loan to HSBC Bank plc and if they default on their obligations investors could lose all of the money invested. The third primary risk is that if at the end of the term the FTSE 100 is down by more than 50% when compared to the level recorded at commencement, investors will suffer a loss in line with that fall. So if the index is down 51% they will lose 51%. Whilst such a scenario would mean that the FTSE in 2015 would need to be at a level not seen since 1992, that and the prospect of HSBC defaulting are not impossible. It is the very fact that it’s not impossible that gives rise to the potential return. On the plus side, if the FTSE is higher at the end of the term the investment will pay the 60% gain.

As with mutual funds, the adviser can move up or down the risk scale using alternative plans to increase or decrease the risk and potential return and thus identify investments that satisfy a client’s risk appetite and return aspirations. Furthermore, an adviser can select from startlingly different pay off profiles and so can create a portfolio that will produce rewards and / or protect downside in varying market conditions and usually maturing at pre-specified times so as to assist or dictate tax planning to maximise the net return.

For example, another structured product offered at the same time that could have been used as a complement, was backed by Barclays, will mature in a different tax year and would pay 100% of any rise in the FTSE 100 over the term again subject to a maximum of 60%. However, this plan would lock in each 15% rise in the index. So, even if the FTSE was down at maturity, if during the term it had reached a level of, say, 45% higher than at commencement then the investment would produce a 45% gain.

Using investments such as the above in conjunction with other complementary offerings and a portfolio of Open Ended Investment Companies (OEICS) will help balance the risk to the investor. Certainly, if the FTSE, or whatever the underlying measurement, performs very poorly the investment will mature at a loss. Or, if the counterparties go bust, the structures will, in all likelihood, produce nothing at all, but in such circumstances the consequences for the rest of the portfolio could also be very dire. It is for these reasons that such a portfolio would only be suitable for those who are prepared to expose their capital to a degree of risk and accept the consequence of that risk resulting in the worst outcome.

Likewise, whilst not all structures have a cap on performance, there is the risk that the use of structures such as those described above could constrain the overall growth of the portfolio, as the returns are capped at 60%; however, that is the price of protection and a basic function of diversification.

So, having established that there is a very good case to utilise structured products as part of a portfolio, how do they work? To illustrate, I will attempt to explain, using approximate figures, what would typically go on behind the scenes in a plan such as the HSBC backed investment described above.

We start off with 100 pence in the pound. Three pence is for the adviser fee / commission, two pence goes on provider charges and that leaves us with 95 pence. Of this, 80 pence is given to the bank which promises to pay it back with interest at the end of five and a half years. Together with the interest, the bank will be repaying 100 pence at the end of the term. A put option is sold to the bank for 12 pence. This is the element that places the capital at risk in the event of the FTSE being more than 50% down at the end of the term. If it is down by, say, 60% they will take 60 pence out of the 100 pence due to be repaid at maturity. The premium from the sale of the put together with the 15 pence that we had left out of our original 100 pence gives us the premium to buy the option from HSBC that obliges them to pay us 60 pence if the FTSE is higher at maturity.

So that’s it in a nutshell, but if you want a clearer description of the net result and a full explanation of the risks, take the time to read the product literature of a few structured products. After the intervention of the FSA last year you can be as good as certain that the documentation is going to be clear, fair and not misleading.

For all those who want to know the detail, there are an increasing number of courses and training programmes available to those who want to gain the requisite knowledge. There are free and heavily subsidised courses available to IFAs via the ‘Education’ section of StruturedProductReview.com. Those that do avail themselves of the requisite knowledge will learn that structured products are not rocket science.

If you are sceptical about structured products, have any reservations about them or if there is anything you want to know more about, or if you think I’m missing something, I’d love to debate the subject with you, so please contact me via StructuredProductReview.com and we’ll publish the debate online and hopefully in the pages of Professional Adviser.

Ian H Lowes, FPFS, Chartered Financial Planner

Ends


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