Understand the Structured Products You Invest In
Closely examining any investment product available in the UK should alert you to the risks involved – some of the structured products sold on the market can be very complicated and potentially toxic even for a sophisticated investor.
Before you even start thinking about using structured investments, you need to understand exactly what you’re getting yourself into. Here, arranged in no particular order of importance, are the factors you, as a potential investor, should look at:
*Caps: Many structured product providers put caps on the maximum return you can make for your investment. If that cap is set too low, you can find yourself very quickly hitting the maximum return over the duration of the investment – especially if the upside participation rate is also very high.
*Counterparty risk: If the markets believe a financial institution is much riskier (that is, that it may in the future default on its debts), they tend to demand a higher rate of interest for lending to it.
But that potential for return comes at a cost – the bank is perceived as being riskier and you can lose your money if it goes bust – and banks do go bust, as recent events testify.
*How the barrier can be breached: In some structured products, if the barrier is breached on any day within the full term, at any time, you can be in trouble – and your capital protection destroyed. This event may matter if trading during the day on a major index results in an anomalous sudden collapse in prices, which then proceeds to vanish by the end of the day.
*Absence of dividends: Remember that structured products don’t pay out any dividends that you may have made by investing in the underlying equities. For a large blue chip index such as the FTSE 100, this is important; ensure that your return or upside properly compensates you for this loss.
Tax position: Autocalls are very popular because they can provide an annual payout that’s taken as a capital gain, not taxed as income.
Here are some other factors to consider:
*Capital protection parameters: If you’re offered capital protection, understand what this really means. Is it contingent on a barrier, and what happens if that barrier is breached? Don’t underestimate the possibility that markets can fall by more than 30 or even 40 per cent, and when that happens, many structured product barriers are broken.
*Safety versus the potential for return: Don’t be surprised when you discover that the more ‘safe’ a product looks, the lower the potential for return. Many building society products, for instance, offer capital security but the returns can be absolutely derisory. Equally, some structured deposits look very safe but the upside is very limited.
*Costs: Structured products are like any investment – they incur costs throughout the structuring process. The financial institutions issuing the options make a charge, as does your financial advisor.
*Early relinquishment rules: Nearly all structured products sold through independent financial advisers (IFAs) involve a fixed term – usually around five to six years. You can sell your investments in the plan within that period of time but doing so usually incurs quite substantial charges and dealing is usually restricted to one day every month. For that reason, don’t leave a plan early unless absolutely necessary.