Structures put on firmer footings

Investment groups selling capital-protected structured products are taking measures to improve their transparency and security, prompted by an ongoing review by the Financial Services Authority (FSA).

Following investigations – and subsequent administrations – of structured product providers such as Arc, NDFA, Defined Returns Limited and Keydata, attention is focusing on the strength of the counterparties providing “capital protection” for these products and the disclosure of counterparty risk in marketing literature.

“The demise of NDFA and Keydata has prompted investors and financial advisers to sit up and take far more notice of where, and how, the money within structured products is actually invested,” says Justin Modray, founder of Candid Money (www.candidmoney.com), an advisory website. “Gone are the days when all they worried about was simply whether the stock market index used by a product hit its target.”

Structured product providers buy “insurance” from a counterparty, usually a bank, in the form of zero-coupon bonds that have a redemption value equivalent to the total amount invested. Derivatives are then used to deliver income or growth, linked to movements in a market index.

But if the counterparty fails, the provider cannot return the original capital invested and investors lose all their money. So the “protection” is not watertight.

The FSA began an inquiry into structured products after the Financial Ombudsman Service (FOS) alerted it in May to an unusually high level of complaints about Lehman-backed structured products, raising fears that investors had not understood the risks involved.

A review of the advice given on all structured products is now underway and will conclude in January – with investors who received unsuitable advice eligible for compensation.

But providers are also taking steps to improve their procedures and due diligence.

Morgan Stanley, for example, in some cases uses UK gilts to back its products and sets aside collateral equal to the full value of the derivative contracts used in those products.

But to widen investors’ choices, the bank still offers a line of structured products backed by lower-rated Morgan Stanley securities.

Its latest Protected Growth plan offers investors a return of 100 per cent of their initial investment, even in a falling market, plus added returns if the FTSE 100 Index appreciates. Alternatively, its FTSE Best Entry Growth Plan includes a built-in market timing feature that enables investors to enter the market at the lowest monthly index level during the first quarter. Investors receive twice any growth in the FTSE 100 index up to a maximum return of 96 per cent.

But Morgan Stanley warns investors that if the FTSE 100 index level at maturity is below 50 per cent of the “best entry” level, then capital is at risk and will reduce 1 per cent for each 1 per cent of negative FTSE performance.

“We know that not all investors see the market in the same way and so we are offering a range of products to suit those different market views,” says Marc Chamberlain, executive director at Morgan Stanley.

Other providers have adopted similar measures. BNP Paribas’s line of structured products have been backed by G7 government bonds for several years.

“We welcome the FSA’s review and genuinely believe it will not only be positive for investors immediately but also for the industry, for both providers and advisers in the medium term,” says Christopher Taylor, chief executive of Blue Sky Asset Management, a structured product provider.

Modray of Candid Money also warns his clients to buy structured products from providers who use well-
established third-party administrators as protection in case a provider fails.

But even these safeguards are not enough to persuade some financial advisers to recommend structured products. Tim Cockerill, head of research with Rowan, the adviser, says he prefers investments that are easily tradeable.

“If the regulator didn’t see the problems and nor did the rating agencies, what chance do other mortals have?” he says.

Jason Butler, a chartered financial planner with Bloomsbury, is equally cynical about the role of structured products.

“For the vast majority of long-term investors, structured products offer little benefit and a properly constructed and rebalanced portfolio of low-cost index funds is likely to offer more than acceptable outcomes,” he concludes.