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Wouldn’t you rather have an umbrella?

Ian Lowes, founder of CompareStructuredProducts.com - 08/07/2015

A version of this article was first published by Fund Strategy

Wouldn't you rather have an umbrella

The stock markets, like the British weather, are somewhat unpredictable. Everyone enjoys being out in the sunshine, but if you want to avoid ever getting wet then you’re left with little choice but to stay indoors. But if you take this option, you’ll never go anywhere.

Structured Products provide you with the opportunity to venture out – into the markets, but carrying an umbrella just in case it rains. Consider an auto-call – if it doesn’t rain after two years, you get a fixed amount for each year you have had your umbrella and go back inside with the proceeds.

If it rains, the protection will keep you dry hopefully in time for the sun to come out again, getting a higher return as you’ve had your umbrella for longer.

But just like an umbrella, protection built into structured products won’t save you from complete disaster. So if a hurricane comes along, you’re going to lose your brolly, thus your protection, and get wet along with everyone else. But surely it’s better to have had it in the first place compared to not having it at all?

Let’s put the protection offered by structured products into some context. The barrier level on most structured products linked solely to the FTSE 100 is 50%. Some of the barriers are observed during the term and some, only at the end.

Consider a six year, FTSE 100 linked product with a 50% end of term barrier, which strikes at a time when the FTSE 100 level is 7,000. In order to lose capital from market movements, the FTSE will need to be below 3,500 in six years time. We know that past performance is not a guide to the future, but in its history, the FTSE 100 has never fallen by more than 50% over a six year period.

Furthermore, a FTSE level of 3,500 is a long way down - the last time the index closed below this level was at the very end of the dotcom correction in 2003 and before that, not since October 1995. However, such a fall is not impossible and this is why structured, capital-at-risk products offer good potential returns for investors as the reward for this risk. However, a fall of this magnitude is more of a hurricane or a typhoon than a downpour.

To carry the analogy further, some structured products are made even stronger to withstand a downpour. These defensive structured products offer gains even if the underlying asset, say the FTSE 100, falls up to a pre-determined amount. For some auto-calls, a reducing reference level will be used at subsequent anniversaries, providing a bigger opportunity for the product to mature, but the returns on offer may be lower than a straightforward auto-call.

To put the protection offered by structured products into some real-life context, out of the 117 products that matured in the first quarter of this year, all but one made a gain for investors, accord-ing to StructuredProductReview.com. This one returned capital only.

‘That is because the sun was shining’, I hear you say, but regardless of that, the protection was still there and attractive returns were made by structured products. The average annualised return of capital-at-risk products was 8.37% over an average term of 3.42 years, according to figures from StructuredProductReview.com. The first quartile made an equivalent figure of 11.50%, while the bottom quartile made 6.03%.

Capital-at-risk investments would not be suitable for a client who cannot tolerate a loss in any circumstances, but consider how the structured product will perform relative to other, non-protected investments in everything other than a hurricane. In all weather, other than a consistent, worsening torrential downpour, a structured product should at the very least return original capital and if it’s ‘sunny’, an attractive, pre-defined return should be delivered.

As for a risk averse clients who cannot tolerate any loss, there are ‘capital-protected’ structured products that may prove suitable, although these will still lose money in the event that the counter-party defaults (equivalent to an earthquake and tsunami perhaps). To offer some protection against even this unlikely event, there are deposit based products which potentially benefit from FSCS protection.

Failing that, totally risk-averse investors will be left with little choice other than to ‘stay indoors’ out of the market and consider simple deposit accounts, but with interest rates so low, some risk needs to be taken in order for your garden to grow.

In conclusion, the addition of structured products to a portfolio can reduce its market risk and make sure you’re hedging your bets for whatever weather transpires. Since markets are currently at such high levels, such protection come rain or shine is a sensible consideration for investment portfolios.

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