THE EDUCATION SECTION November 2011 Every month we look at a particular financial topic in a little more detail. This month it is Structured Products ____________________________ What is a Structured Product? Structured Products can be any one of a wide range of investments and can offer - • income, • capital growth, • or a combination of both. Most structured products tend to be open to new investment for a short period of time. Funds will then usually need to be tied up for between one and ten years. Some structured products offer full capital protection, but others offer partial or no capital protection. What are the benefits of Structured Products? • They combine the benefits of stock-market returns, with limited downside risk. How do they work? • Structured products offer returns based on the performance of underlying investments. Many products are linked to a stock market index such as the FTSE 100. The underlying investments may involve different firms based in various countries. • A typical structured product will have 2 underlying investment components: a note . This component is used to provide capital protection. It may pay interest at a specified rate and interval, and may repay some or all of your original money at maturity; and a derivative . This component is used to provide the potential growth element that you could get at maturity. • Investors are usually offered only a share of any increase in the level of the index or asset price which occurs during the term of the investment. How is your capital protected? • Even if a product offers ‘capital protection’ it can sometimes fail, causing you to lose some or all of your original money. For this reason, if you decide to invest in structured products then it is wise that they form only a small part of a balanced investment portfolio. You should also consider spreading your investment between several products which rely on different financial institutions to protect your money. It is important to be aware which financial institution is ultimately responsible for offering any ‘capital protection’. • Structured products offer two broad types of capital protection. o Full - described as ‘100% capital protection’, ‘capital security’ or a ‘capital guarantee’. This aims to return all the original money invested at the end of its term, regardless of any fall in index level or asset price. Remember, though, that the cost of offering this protection will affect the returns you get, and there is still a chance you could lose some or all of your original money. o Partial - often offered by ‘structured capital-at-risk products’ (known as ‘SCARPs’). This aims to return the original money invested at the end of the term unless the index or asset price to which the product is linked has fallen below a predetermined threshold. What about structured deposits? • Some structured products are deposits rather than investments. Structured deposits (often marketed as ‘guaranteed equity bonds’) can only be offered by firms such as high-street banks which are able to accept deposits. • Your money is treated as if it is in a restricted-access bank account but, unlike a traditional savings account which pays a fixed rate of interest, the interest you receive will depend on the performance of a stock market index or asset. • It is important to note that you may not be covered by the Financial Services Compensation Scheme (FSCS) if the firm holding your deposit goes bankrupt. Key risks and product features. The following list is not exhaustive and not all risks or features are applicable to each type of product. • Credit risk – a product may be designed and marketed by a ‘plan manager’, but the returns and guarantees are generally provided by a third party. If that third party goes bankrupt, you could lose some or all of your money, even if a product is called ‘protected’ or ‘guaranteed’. You may not be covered by the FSCS if this happens. When selecting a suitable Structured Product it is important to assess the credit worthiness of the relevant counterparty by reviewing their CDS rating . • Market or investment risk – if the return of your original money depends on the performance of a stock market index or asset, then if the level of that index or asset falls during the term of the investment you may lose some or all of your original money. If this happens, you could lose your original money very quickly. • Liquidity risk – the benefits offered (such as capital protection) are usually only available if the product is held for the full term. It may be difficult or expensive to access your money before the end of the investment term. • No dividend income – even if a product is linked to the performance of a stock market index, you will not receive any dividend income from the companies which make up that index. • Capped returns – many products restrict or cap the level of the return you can receive, so if an index or asset price rises above the level of that cap, you do not receive additional returns. • Averaging – the return offered by some products can depend on several measurements of index levels or asset prices during the life of the investment. While this can protect you from short-term falls in an index level or asset value, it may also prevent full exposure to any gains. • Limited participation – many products only offer a proportion (for example 50%) of any gains made by the index or asset to which they are linked. • Inflation – even where a product is marketed as ‘100% capital protected’, the real value of the capital can suffer significant erosion by inflation over the term of the investment. • Tax – the tax treatment of structured products depends on their legal structure and on any tax wrapper in which the product is held. Structured products are often complicated. You should seek professional advice if you are in any doubt about the potential risks and returns involved. You could lose some or all of the money you put in to these products, so make sure you understand the risks before investing.