Counting the cost of a 'capital guarantee'

The recent history of banks and the City has shown all too often that this year's hot new product is next year's flop, or, worse still, a mis-selling scandal. And it could well be that one of the recent past's apparently "must-have" investments – the not-so-catchy-sounding structured products – could be going the same way, as a series of providers have now entered into administration. So is this yet another horror story of investor disappointment, or just a blip?

Structured products are marketed as the ideal option for more cautious investors looking to protect their capital from volatile stock markets, while still enjoying high returns. If all this sounds too good to be true, that's because it is, according to many critics who would argue that investors are unaware of the complications and the potential risks involved.

"Investors are attracted to headline rates of return without understanding what they are investing in," says Danny Cox from independent financial adviser (IFA) Hargreaves Lansdown. "Structured products are complicated and not as guaranteed as the literature says they are. Generally, investors in structured products end up disappointed with the returns."

At face value, structured products are fairly simple investment vehicles. They offer exposure to growth in a particular stockmarket index, over a set period of time, while limiting the risk of losses by promising the return of all or most of the initial investment, plus a return linked to the underlying index. But dig a little deeper and things soon get more complex. Even the most basic product, often linked to the FTSE 100 index, will offer a proportion of its growth with the return of capital, but stipulate that this guarantee is only viable if the index does not fall by a certain percentage, typically 50 per cent.

There seems to be demand for the idea of stockmarket returns with guarantees attached, often sold by independent financial advisers. Last week, for instance, Barclays Stockbrokers launched two FTSE 100-linked structured products – the Protected FTSE 100 and the FTSE 100 Accelerated Returns Investment. The former is targeted at cautious investors and has a five-year term, offering returns of two times the rise in the FTSE 100, to a maximum of 45 per cent, while the latter offers three times any rise in the index, again over five years, up to a return of 75 per cent.

Sounds good on the surface, and this type of product can potentially play an important part in an investment portfolio, but the problem lies in the fact that structured products rely on a third party to meet the guarantee. Structured-product managers use part of the investors' capital to buy derivatives to deliver either income or growth. They then reduce the risk by using the rest of the money to buy bonds issued by one of more banks. This is designed to provide the capital protection for investors, but, if that counterparty goes to the wall, the protection disappears.

So, as well as the risk that the investment will underperform, investors have to question the safety of their original investment. This problem has been highlighted with the announcement last week that NDF Administration Limited (NDFA) and Defined Returns Limited (DRL), leading providers of structured products that were backed by Lehman Brothers bonds, have gone into administration. Last month, the Financial Ombudsman revealed that complaints about Lehman-backed structured products have almost doubled since May. What's more, Keydata Investment Services, which specialised in structured products for individual investors, was placed into administration by the Financial Services Authority (FSA) in June.

It is crucial that potential investors of structured products know that, along with the risk associated with relying on a third party for the guarantee and whichever market is being tracked, these products can also carry significant risk when you look into the details of any clauses. Many structured products will only offer investors all their original investment back as long as certain criteria are met – for example, as long as the underlying index hasn't fallen below a set level. But there are even more complicated plans offering what's called "leveraging". These may offer 2 per cent investment growth for every 1 per cent growth in the index, giving investors the chance to multiply their returns. Conversely, this can result in investors multiplying their losses, with a 2 per cent fall for every 1 per cent fall in the index, for example. Products that track several indices at once can be even riskier as returns can be pegged to the performance of the worst performing index – not good for the investor.

But does all this mean structured products have no place in the investment world? Many would argue that the risks associated with such products do not necessarily mean that investors need to steer clear. With understanding of the potential pitfalls, they can be a useful tool for investors looking to diversify their portfolios away from cash savings, property, company shares or unit trusts.

"The clearest benefit is that you get protection of your capital, not 100 per cent, but there is a level of protection there," says Fraser Donaldson, a principal consultant on investments at financial information service Defaqto.

There are also benefits in terms of consistency of returns. "They give you a reasonable idea of what your returns will be, unlike a managed unit trust fund where you're never quite sure what you're going to get," he says.

Others argue that with interest rates so low, investors have little choice than to cast their net wider, even if there is an extra element of risk; not often at first clear, particularly as many structured products are marketed as having guarantees in place. "Many people simply cannot exist on the current level of income offered on deposits," says Colin Jackson, of IFA Baronworth Investment Services, "so they have to look at alternatives, and structured products are one of them, but they have to resign themselves to a higher element of risk."