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Investing for the long term.

Byline: TREVORLAW

Most equity markets have rallied after the last few months but their volatile nature over the last few years has put off many investors. If there was an investment which offered equity exposure, good upside potential and downside protection then this may appeal to some investors. This is exactly what Structured Products aim to achieve.

What are structured products? At their most basic, structured products promise to protect some or all of the money you invest while providing some growth on your investment or a measure of pre-defined income throughout the life of your investment.

They are fixed term products which mean you have to be prepared to lock-in your money for the term of the investment (often five or six years).

The investments are structured by leading investment banks which allow more product innovation than, say, with OEICs or unit trusts. Growth plans often offer geared or accelerated returns, for example, linked to the performance of an established index such as five times any growth in the FTSE 100 index over the term of the investment.

How do the products work? They often have simple aims to suit different investment objectives but they involve some complex financial tools "behind the scenes" to help achieve them. They have two component parts: the first to protect all or part of your investment, the "safety net"; the second to provide the growth paid to you when the product matures, or the income paid out during the term of the investment.

The bulk of your investment is used to provide a safety net which ensures that you get all or part of your money back at the end of the fixed term - this is called capital protection.

Some plans offer 100 per cent protection i.e. the full return of investor's capital at the end of their term while others may offer "downside" or "soft" protection to limit potential losses should markets fall. The capital protection element takes the form of a zero coupon bond, a form of corporate IOU generally from an investment bank or other large financial institution.

Futures and options are the main types of derivatives. Options are simply a right to buy (a call option) or sell (a put option) a particular asset on a future date. For the cost of a small premium you can fix the future price of an asset on a certain date. When that date arrives you can choose to exercise your option to either buy or sell the asset depending on the underlying market conditions.

If markets move as expected, the purchaser of the contract can exercise their option and make their gains; if markets move in the opposite direction to that expected, there is no financial benefit to exercising the contract and all that is lost is the cost of the premium.

The derivative components of a structured product are taking simple bets about whether the underlying assets will rise or fall. It would be high risk to place just one bet on one set outcome for a financial product lasting several years.

Instead financial institutions use multiple underlying options to accommodate many different outcomes and therefore spread the risk. Most structured products track a single index or asset class - the FTSE 100, Euro Stoxx 50, Nikeii 225 and S&P 500 feature frequently. By placing different options on the movement of shares within each index, managers are able to hedge their bets and spread the risk by not placing all their eggs in one basket.

Structured product providers are becoming more imaginative. On the face of it, more generous, but let's not get too carried away. Annual kick-out plans offer the potential for early maturity usually in return for an index being level or above its starting or strike price.

A key element to structured products is counterparty risk. The capital protection offered by structured products is provided by a counterparty, which is usually an investment bank. The higher the credit rating of the bank then the safer the investment should be. Often, higher returns are available but these are plans backed by counterparties with less financial strength and thus more risk which investors should take into consideration.

What about cost? With structured products, charges are generally "built in" to the terms, so they've already been considered in the advertised returns with no additional costs or surprises so long as you remain invested for the full term of the investment. Due to the fixed term of a structured product, investors face higher exit charges if they wish to leave a product early. It is therefore essential to leave an adequate emergency fund which is liquid - no different to other investments.

The tax treatment of these investment vehicles varies but they are often available via ISAs, ISA transfers and SIPPs so tax-efficient wrappers such as these are client-friendly. Direct investments aimed at growth are most often subject to capital gains tax but your annual allowance (currently pounds 10,600 per annum) can be used to mitigate any gains.

So with markets behaving as they have been and (still) a more than tricky economic backdrop, structured products could form a useful part of investor portfolios in the current conditions and going forward.

Trevor Law is a director with Merito Financial Services located near Solihull. E-mail: tilaw@meritofs.com
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Title Annotation:Features
Publication:The Birmingham Post (England)
Date:Feb 23, 2012
Words:887
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