Ian Lowes, founder of CompareStructuredProducts.com - 18/03/2015
Low interest rates have caused savers to search further for returns on their cash. This may involve going beyond more traditional investments to ones that offer better returns, but similar protection to a deposit account.
A behavioural survey, recently released by the regulator, the Financial Conduct Authority, involved questioning 384 investors online to investigate how well they understand and value structured deposits. Structured deposits are essentially fixed-term deposit accounts, where instead of interest being earned at a set or variable rate, the return is fixed but depends on the performance of the underlying asset, such as the FTSE 100.
So, for example, a deposit plan might offer 30% return on the capital after 5 years as long as at the end of the investment term, the FTSE 100 is at or above the level when the investment started.
While nothing is completely risk free, structured deposits are designed to return investors’ original capital as a minimum at maturity. As with most UK deposit accounts, structured deposits usually include the potential benefit of protection should the deposit taker become insolvent during the investment term. This protection is provided by the Financial Services Compensation Scheme (FSCS) and UK eligible claimants have a right to claim up to £85,000 per individual per institution in such circumstances.
The survey asked what the investors expectation of FTSE performance would be over the next five years, and based on that estimation, investors were asked to predict the returns of five structured deposits, with varying degrees of complexity, that were hypothetically constructed for the survey.
The conclusion was that investors over-estimated the returns potential of structured deposits by 9.7% over the five year term, with seemingly very precise detail of the extent of such over-estimation. However, both the methodology and the findings of the survey warrant analysis in finer detail – and the detail appears to throw up some questions and concerns that, in our opinion, inhibit its wider applicability.
The 5 year deposit rate used for comparative purposes in the survey was based on the best rate available, at 3% per annum. However, the hypothetical structured deposit rates were based on products that were far from competitive, let alone the best rate available, as far as the Independent Financial Adviser (IFA) arena is concerned.
CompareStructuredProducts.com has analysed those products available in the IFA space in early 2013 – the time that the paper states the products were selected from. Whilst we cannot comment on the products that were being sold over the counter by banks and building societies, some of the products that were hypothetically constructed for the purposes of the survey bore little resemblance to those actually on offer in the IFA space, and were clearly very poor value. So, comparing the best of cash with some pretty ropey, if not the worst, structured deposits, and extrapolating observations about customer behaviour is perhaps not as meaningful as a study designed to be academically objective is intended to be.
For example, the ’Basic’ structured deposit ‘designed’ for the survey offered 50% of the growth in the FTSE, whereas in early 2013 you could invest in a deposit that offered 100% of the growth (subject to final six month averaging).
Therefore, the participation rate of the ‘Capped’ product in the survey, 100%, matched that of a real product that had no cap, available in the IFA space at that time, which is a significant difference in the offerings.
And the fifth product type, the ‘Cliquet’, used in the survey was not on offer at all in the IFA space at that time, and to the best of our knowledge at CompareStructuredProducts.com hasn’t been for some time.
In addition to these specific product issues, more evidence of the lack of actual worthwhile comparability of the products hypothetically designed for the survey with actual IFA distributed products of that time and today, is the fact that the assumed fees incorporated in the survey products were 7.5% - which bears little resemblance to products seen within the IFA market. Looking at CompareStructuredProducts.com, charges were around 5% to 6% on deposits available at the time and that included an adviser charge of around 3.
There are also other aspects of the technical analysis that concern us, which might account for some of the apparent over-estimation of anticipated returns by the survey respondents.
The kick-out product example used in the survey is described as offering a 4.5% coupon for each year held. The paper and therefore, presumably, the survey analysis, suggests that this product would be expected to mature after two years. If this occurred, clearly the product would produce a gross return of 9%, 4.5% for each year. But the paper states that the expected payback would be a gross return of 4.9%. Whether this apparent error had any impact on the survey and its findings is not clear, but it is not inconceivable that, in the worst case scenario, this could account for an element of the headline findings.
The kick-out structured deposit in the survey, compared against the other product types, showed the smallest gap between investor expectations of the performance of the product and FTSE expectations. This highlights how investors may find it easier to think about products in terms of annual coupons that can be achieved in the simple event that the FTSE is higher, rather than a percentage level of participation in the rise in the index, or the complexities of a ‘Cliquet product. Also, kick out products are a main-stay, perhaps as much as 70%, of structured products, as opposed to what has been seen on the High Street, via banks and building societies.
One of the outcomes the Regulator is quite rightly looking to achieve is that the structured products offered are reasonable and fair propositions and offer good value for money, in other words attractive potential returns for the risk taken. It’s fair to acknowledge that this may not always have been true of some of the products in the past, and this was particularly the case on the High Street, where the products distributed have, in our opinion, often fallen short of offering reasonable value for money.
However, in the IFA space that is represented by CompareStructuredProducts.com, particularly in recent years and today, there have certainly been products offering investors good value, attractive returns for the risk taken. The results of the 80 IFA distributed structured deposits that matured in the twelve months to the end of February 2015 show real evidence of this.
The average performance was 5.47% per annum, over an average term of just over 4 years. However, the top quartile performance was an average annualised return of 7.74% (for balance and completeness, the bottom quartile average was 3.28%). These are surely amongst the best returns achieved by cash based investments over recent years, in the real world, as opposed to poor high street or hypothetical products with hypothetical returns, and have no doubt led to some very happy investors, who are glad they selected and included structured deposits in their portfolios.
It is accepted that no analysis or survey will ever be water tight, especially where hypothetical inputs are necessary. Equally, regardless of any oversight shortcomings, such as conflating the different distribution channels that are so clearly evident in the UK, and thus discussing all products as one set with no differentiation, there are extremely valuable aspects of the FCA’s latest work. And, if it ultimately leads to poor value or poorly conceived and developed or poorly targeted structured products disappearing from the market, it will be a good thing indeed.
The FCA say themselves that structured deposits have a place in the market. We certainly agree and believe that while no single solution is ever going to be the holy grail of investment, well designed, fairly created and appropriately advised upon structured products, with their USPs of known outcomes in known circumstances, are worthy of consideration for an investor’s portfolio - and we are keen to see the market continue to evolve for the better.