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Utilising structured products to reshape returns and mitigate risk

Ian Lowes, founder of CompareStructuredProducts.com - 16/03/2016

Global uncertainty currently characterises markets with muted growth, troubles in China and fiscal tightening in other economies, while monetary stimulus is being used elsewhere to fight off deflation. It’s no wonder that markets are choppy which isn’t attractive for investors, most of whom simply want smooth consistent returns whatever macro headwinds are flailing the markets.

At the time of writing, the average year to date closing levels of the FTSE are more than 12% lower than over the same period last year. Investor fear around the short-term security of their money can lead them to avoid investing altogether. A good financial adviser knows that this isn’t the answer but taking steps not only to protect capital, but also to provide positive returns, is the aim when creating a balanced investment portfolio.

Generally speaking, growth structured products allow positive returns to be made where little, or no, market growth of the underlying measurement, say the FTSE 100, has occurred.

Three growth based structured products currently available may be useful for consideration in these circumstances, as stand-alone solutions or, as part of a mini portfolio to provide a protective corner of an investment portfolio, reducing the risk of market falls, while still participating in market rises.

All three investments are designed (subject to continued counterparty solvency) to track the fall in the FTSE 100 index if it falls by more than 40% over the six years. They are all designed to return the original capital only if the market is down between 20% and 40% (a welcome outcome in such a scenario) but if the index falls by less than this amount or rises, they are designed to produce varying outcomes.

Product 1:

The investment that has the highest potential return requires the FTSE 100 to rise by only 7.3% to produce its maximum gain of 73% at the end of six years, as it offers a return at maturity of ten times any rise in the index. If the index falls over the term it will produce no gain and a loss if it has fallen at maturity by 40% or more.

Product 2:

The second investment offers a lower maximum return of 63% but this will be achieved if the FTSE rises by 2.6% or more. However, unlike Product 1, this investment is designed to still produce a gain as long as at maturity the index is above 90% of its starting level. In this event the return is calculated as five times the extent to which the index is above 90% of its starting level. Therefore, if the index has fallen 2%at maturity, being 8% above 90%, the investment is designed to pay a 40% gain. There will be no gain if the index falls by more than 10% over the term and a loss to the original capital if it has fallen at maturity by 40% or more.

Product 3:

Our third investment has the most defensive feature but the lowest maximum gain albeit this will still result in a 60% gain being achieved if the FTSE is at or above the starting level at maturity. The return is calculated as three times the extent to which the final index level is above 80% of its starting level and therefore if the index has fallen by 10% this investment will still produce a gain of 30%. A fall by more than 20% over the term will produce no gain and a fall of more than 40% will, as with the others, give rise to an equivalent loss.

In an ideal world, all the nuances will prove academic, the market will rise and all three investments will produce their maximum returns, but, of course, we do not know whether we face an ideal world.

Dismissing Product 1 and instead, settling for the lower maximum, 60% gain offered from Product 3 might seem the better option for those who aren’t trying to achieve the highest returns but who are instead, looking at improving the returns that would be achieved if the index does not rise. However, this will mean exposing capital to a single counterparty bank and whilst counterparty failure is unlikely, such an event could result in a catastrophic loss so, as ever, it pays to diversify.

A better solution might be to blend all three products together which, if done equally, caps the maximum return at 65.33%, which would be achieved if the index is up by 7.3% or more, whilst at the same diversifying counterparty risk, as each investment has a different counterparty bank.

Blending together a range of structured products with different risk/return profiles can provide attractive gains even in less than favourable market conditions. In today’s climate with continued global uncertainty and more obstacles looming overhead, the capital protection and potential attractive returns offered by these products may be serve as a well-wanted cushion when things get rocky.

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