Structured Products – do investors fully understand the risks?

There has been much debate this week about the risks associated with Structured Products

Tim Myatt PhD
Author Tim Myatt PhD
Date 30th April 2013

Following Martin Wheatley’s headline-grabbing comments, ” … almost like spread bets on steroids”, there has been much debate this week about the risks associated with Structured Products. The FCA expresses the view that many structured products have too many moving parts, leaving investors unable to make rational decisions about them. Although Structured Products are intended to offer protection against many types of risk, and some advisors see their benefits, others find them complex and believe that they may not best meet the needs of investors. Among several, Rachael Revesz’s piece in the New Model Advisor sought to highlight some of the issues.

What are Structured Products?

Structured Products are market-linked investments, based on derivatives, sold as a pre-packaged strategy to provide protection against particular risks, such as currency risk, counterparty risk, loss on the principal investment or inflation risk. They are popular with many first time and risk averse investors. Principal protection, for example, seeks to safeguard the holder’s initial investment against a drop value, diminishing the potential upside, due to the cost of the protection, but limiting the downside.

Oxford Risk shares the concern that these risks are not often fully understood by investors or appreciated by their advisors.

What are the risks that may be covered?

Though Structured Products will offer different levels of protection here are some of the risks that may be covered:

Protection against Market Risk is one of the most common uses of Structured Products. Many investments will be equity based; the price movements of those equities, and the indexes based on them, will often be highly correlated, leading to generalised rises and falls in value. This is Equity Market Risk. However, Market Risk isn’t limited to equity-based investments; causal factors may also include major natural disasters, recession, political turmoil, changes in interest rates, and terrorist attacks.

Currency Risk arises when overseas investments are purchased in the local currency rather than the investor’s home currency. For example British investors might purchase US shares in US Dollars rather than Sterling. Additionally, some Structured Products available to investors in the UK are linked to foreign indices, for example the S&P 500 or the Dow Jones. This means that the actual value of the investment is subject to not only the usual volatility, but also to changes in the exchange rates between two currencies; a slide in the value of the Dollar against the Pound could potentially lose more value for the investor than a rise in the index-linked Structured Product.

Protection is also offered against Inflation Risk, and with inflation running high in many countries this has currently proved popular among investors across Europe. For example, fixed term deposit plans are now being offered that offer a minimum level of return at maturity or 100% of the growth in the Retail Prices Index (whichever is the greater). Investors may however not fully understand these Structured Products, or assume that “inflation-linked” means that all products are fully secured against Inflation Risk. Many protect only against increases in inflation, but if inflation is high at the start of the investment and relatively unchanging through its period, the level of protection these products afford the investor is questionable.

One of the newest type of index linked Structured Product contains a ‘kick out’ mechanism that will return the initial capital to the investor, with no gain, if the index falls below a certain barrier. This barrier might be either a percentage of the index at the time of the initial investment, or a given index level. Such products are rarely offered linked to a whole index, but more often to a small number of stocks. This results in complex combinations of possible parameters and interactions between the chosen stocks that are often not understood by investors, and therefore contain Equity Market Risk.

Investors seeking sanctuary in Structured Products should also be aware of Counterparty Risk; the danger that a counterparty to the investment experiences financial difficulty or collapses altogether. Since the demise of Lehman Brothers in 2008 and the collapse of a series of global banks Counterparty Risk has gained increasing significance for investors. Some Structured Products can reduce this type of risk by investing through two or more counterparties, however these often have higher minimum investment levels.

How Oxford Risk can help

Oxford Risk has developed a new suite of products that assess factors of financial personality beyond Risk Tolerance. These include Composure (comfort with the fluctuation in the value of investments over their intended lifetime) and fear of catastrophic loss. Other products currently in development will help investors understand their preferences in the face of various types of risk and illustrate the likely effects of their choices.

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