As equity and other markets have recovered this year, some of the world’s biggest providers of structured products have launched or re-issued dozens of new products, suggesting this battered sector is on the mend.

The UK market currently holds 120 structured products, listed on the London Stock Exchange, from 43 firms. Among the most notable providers to high net worth customers are Barclays Wealth and Investec - which offer nine types of product a-piece - and Morgan Stanley, which offers seven. 

Structured products track the performance of an underlying asset or index - such as the FTSE 100 index of blue-chip equities or alternative assets such as commodities - without requiring direct investment in that asset or index. Products typically consist of a bond, to generate the capital protection, and a derivative, to generate returns.

The bond is issued using the bigger part of the customer’s investment - such as £80 from £100. The remainder is used by the provider to purchase an option and cover administrative costs. Typically, investment banks are the issuers of the bonds and provide the guarantee. The sellers of the final product are independent investment managers or wealth management arms of the bond issuing bank.

The sector is not without its problems, however. A criticism that WealthBriefing has repeatedly heard is that the products are foisted onto wealth managers by their sister investment banks, a process regularly pilloried as “product push”.

And the biggest jolt of all to the market has come from last autumn’s bankruptcy of Lehman Brothers, one of the biggest investment banks at the time. It acted, for example, as the counterparty for UK products sold by NDFA, DRL, Meteor Asset Management and Arc Capital and Investments.

Pressing ahead

Its collapse sent a deep chill though sector and caused the global market for these products to retract sharply. Yet UK wealth management operations such as Investec and Barclays Wealth continue to press ahead.

“The UK market is a slightly different story,” Robert Benson, from structured products specialists Arete Consulting, one of a number of industry professionals interviewed on the topic, told WealthBriefing.

“After Lehmans [bankruptcy], investment retracted to better quality issuers, higher credit valued banks and bigger local providers. So overall the UK market did not retract; in fact the UK market has expanded over the year,” said Mr Benson. 

According to Arete, the UK market has historically been parochial, only gingerly venturing away from the FTSE 100 in 2007/2008 before retreating back as the crisis hit. While diversification is beginning re-emerge, the consultantcy says, the FTSE remains very dominant as the underlying asset class, accounting for 75 per cent of issues.

“Before Lehmans we were seeing some expansion into foreign equities and indices but that reversed. Only now are we beginning to see a return to that trend. We are starting to see a lot more products linked to property, like the Halifax property index, but that is still marginal,” added Mr Benson.

The crisis of last year is by no means the first big test of such products, which have, in their different forms, been a part of the investment scene for years. In 2003, for example, Lloyds TSB was fined £1.9 million ($3 million) by the Financial Services Authority, the UK regulator, for mis-selling index-linked bond products to retail customers. The Scottish Widows Extra Income and Growth Plan invested in 30 or so stocks which matured at a loss. As a so-called “precipice” bond, investors were hoping for a high income rate of 10.25 per cent while having no protection on their capital. 

Although high risk products are a perfectly legitimate form of investment, scandal erupted over the way the structured product had been marketed with some retail investors purchasing from a mail shot and without advice. Since then virtually all products protect from falls in the market, known as capital protection. 

Lehman’s demise

The bankruptcy last autumn of Lehman Brothers highlighted the risks that can be overlooked in such products. Many people lost out because Lehman Brothers stood behind the capital guarantees embedded in these products.

It is alleged that some brokers of Lehman products did not disclose the name of the bank to their clients and misled clients over the risk involved in their investment. Meanwhile, UK fraud inspectors are looking into how these products were sold. Regulators in Singapore censured a number of firms earlier this year for alleged shortcomings connected to sale of these products.

In total 6,000 British customers lost £107 million ($173 million) of investment. No compensation could be recouped from Lehman’s because as the issuer of the bond, and not the retailer, no direct civil liability could be established. 

Their case was taken up by Conservative Member of Parliament Ed Vaizey, who was critical of the UK regulator’s response to the issue.

“I began the campaign to get the FSA to look in to this issue and to allow individuals to go to the financial ombudsman with their complaints,” said Mr Vaizey, speaking to WealthBriefing.

The FSA began a wider implications review in May, eight months after Lehman’s collapse, which was initiated in response to a growing number of complaints to the financial ombudsman.

“That is something I shall be keeping an eye on,” added Mr Vaizey. “No one has so far been compensated through formal channels and any compensation that has been received has been from investors contacting the provider directly and making a deal.”

As part of the wider implications process all complaints to the ombudsman were put on hold and the FSA has yet to confirm what kind of penalties will be levelled at those selling Lehman’s products.

Variations on a theme

On top of the basic structure, outlined above, products are offered in a number of variations.

To start, many structured products are so-called Accelerated Trackers following an underlying asset with a geared upside and a downside that follows the index or asset down at a 1:1 ratio - normally once the underlying has dropped below 50 per cent of its original value. Otherwise the product will offer full capital protection regardless of the final state of the underlying.

The level of capital protection also varies depending on the desired level of risk, whether that be the final level of the index - for example, 40 per cent growth rather than 20 per cent over five years- or the time period before maturity - such as Investec’s FTSE Geared Returns Plan that offers 40 per cent for three years and 80 per cent for five years.

An example of an index-sensitive optioned product is the Arc Protected FTSE Growth Plan, from Arc Capital & Investments (ARC).

The first option is fully capital protected and offers 18 per cent growth or 50 per cent uncapped participation in the FTSE100 at maturity. So if the index ends exactly where it started, customers get their investment back plus 18 per cent.

The second, point-to-point, option offers 42 per cent growth, or 50 per cent uncapped participation; investors lose 1 per cent of their capital for every percentage point the index falls below half of its initial level if it has dropped by maturity.

“The general consensus is that in the longer term the Index will move in a positive direction, even if there are ‘corrections’ on the way. Whether after five years it will be ahead by 42 per cent remains to be seen so this is a great way of hedging one’s position,” said John Gracey, ARC Director.

Next, investors can choose their overall level of time commitment. With lock-in and kick-out products customers can choose the option of exiting before the product’s full maturity – for example, after the first, second, third or fourth year of a five year plan. 

The Barclays Wealth FTSE Generator is a 6 per cent return, six year product. It kicks-out investors after three years, with an 18 per cent return, if the index has already reached its maturity target by that point.

As already mentioned, some products are innovating by diversifying the index or asset class they follow. Hence, for instance, the Gilliat Lock-in Growth Series 1. This can be linked to any combination of three different asset classes: UK equities, commodities and property. The available underlying indices are the FTSE 100, the S&P GSCI - ER Index, and the FTSE EPRA/NAREIT developed Europe Index (the latter being a real estate index).

Collateral

A further recent development is collateralisation, as with Vontobel’s collateral secured theme certificates and Morgan Stanley’s FTSE Defensive Gilt Backed Growth Plan.

Vontobel’s product followed a decision by Scoach Switzerland - the Swiss exchange for structured products - and the Swiss Structured Products Association to develop a full-blown collateralisation service, now available on the Swiss Exchange.

The motivation for collateralisation goes back to the fact that investors take on the default risk of the bond issuer. Hence Lehmans is not liable to compensation claims from those who lost money on its bond-backed products. Since the creditworthiness of issuers has now become a significant worry for potential investors, the collateralization service was conceived to reduce issuer default risk.

For collateralized products traded using the Swiss scheme the bond issuer deposits liquid assets - SNB and ECB-eligible bonds, highly liquid equities or cash - with the SIX Swiss Exchange. The amount of collateral must also vary with the value of the product.

With Morgan Stanley’s product, cash or other similar liquid assets are placed into a segregated account by the issuer to the value of the investment. Should the bank go into liquidation, investors would have access to the value of the assets in this account on that date. The plan invests in Preference Shares and the issuer of the shares uses share-income to invest in government bonds which are used to help secure capital. As plan manager, Morgan Stanley will place cash, or other liquid assets, into a separate account on a daily basis to act as collateral to the full value of the derivative contract.

Difference of opinion

Nonetheless, some firms, such as Pictet, the venerable Swiss private bank, have traditionally given structured products a wide birth, and despite other banks’ enthusiasm, IFAs can still be still very wary.

“They offer very poor value for money and are much too complicated. We have been negative on them for the last ten years,” said Mark Dampier, head of research at fund manager Hargreaves Landsdown.

“Basically the costs are hidden and customers just aren’t getting a great deal, getting a low percentage return on an investment rather than 100 per cent that you would get with a fund. I can see that it’s an easy sell because they are capital protected. But then what does capital protection amount to? Look at Lehman brothers, no one expected them to go under,” Mr Dampier said.

However, the real issue with Lehman’s products is not so much the bad-fortune of the bank, or some inherent flaw in the product, but that investors had been misled by terms like ‘100 per cent capital secure’ used by plan managers.

“There is a subtle distinction between the terms ‘guarantee’ and ’capital protection’. A guarantee implies that you will always get your money back. Capital protection likewise implies your capital will be returned, however this is conditional upon the bank being solvent in five years time. Investors should be aware that the term ‘guarantee’ is also not without risk, as the promise to guarantee capital is only as good as the counterparty providing that guarantee,” said Marc Chamberlain, executive director of Morgan Stanley.

So although structured products may not offer spectacular returns, that very much remains a matter of risk appetite. 

“Investors, especially nowadays, go in with open eyes the counterparty credit risk in structured products is well documented and highlighted in the literature. However this risk is not unique to structured products, every investment product contains an element of credit risk. It’s only that with structured products the risk is concentrated whereas in a UCITS fund, for example, it is more diversified,” added Mr Chamberlain.

Mr Vaizey’s constituent lost £200,000 of investment on his structured product -the entire revenue generated by the sale of his company. But while that amounted to his livelihood, structured products are perhaps more suited only to much larger HNW portfolios, sitting alongside other forms of investment.

Looking ahead, the two key issues for this market are clarity and diligence. Clarity: within the literature given to customers, of the costs and risks involved over the five or so years of investment. Diligence: on behalf of advisors and plan managers to research and understand the bond issuer, or counterparty, and the worth of their credit - something that clearly did not work as it should last year.

“The whole counterparty question has been put under the spotlight. People are beginning to understand what it is, but now need to understand how to properly asses counterparty risk. It is more than just a question of credit ratings. For example, I can get two different CDS - credit default swaps - quotes for a single bank. Providers need to be looking at a wider picture: bond yields, stock prices, liquidity ratios and so on,” argues Adrian Neave, managing director of Gilliat Financial Solutions.

Costs and Transparency

One example of the due diligence providers can undertake is supplying their customers with a clear picture of the product’s costs. According to Hugh Adlington investment director at UK-listed Rathbone Brothers, it is often possible to reverse engineer a product to work out what amount the provider or distributor is taking out and how competitive the pricing is.

The structured products market continues to grow and diversify into numerous indices and asset classes. Most importantly, perhaps, they are a way of managing risk. For private client portfolios structured products can be used to mitigate the risks taken on other forms of investment. With increased regulation, and a lot of burnt fingers, it is highly unlikely that we are going to see another major bank collapse, especially not within the next five years. So although the institutions issuing the underlying bonds are not infallible, investors can be at least be confident their product will still exist in five year’s time, even if the markets aren’t performing.

The major issue remains whether the structured product industry - including that many linked chain from bond issue to marketing material that the FSA find so interesting - can manage to make itself transparent and accountable enough to be accepted by a financial services sector looking to redeem itself in the eyes of investors.