If it sounds too good to be true…

In a climate where interest rates are very low, it is easy to be tempted by the prospect of high returns for what can seem like little risk. However, there is always an element of risk in any investment so it is important to explore what is behind the façade of any opportunity.

Structured products, or structured notes, claim to offer the highs of riskier assets without the lows. They work by combining investment in a low-risk asset, like a fixed-term bond, with a smaller investment in a high-risk asset, like equities or gold. Some or all of what you invest (your ‘principal’) is protected so that you get it back at maturity. If various conditions are met, you may also receive a proportion of any growth from the high-risk asset throughout the term.

So far, so simple. However, we have been approached for advice from people who have lost money through structured products; in one case their pension fund shrunk 75% within a year. If you scratch the surface, you can see just how complex – and risky – these investments can actually be.

First, how protected is your principal really? Structured products are not covered by any compensation scheme, so it is you that is taking the credit risk. If the issuer fails, you could lose your entire investment.

You can only get your principal back if you see the investment out to maturity so it is also highly illiquid. With no established trading market as there is for standard bonds, if you do need to exit early you may not be able to sell structured notes easily and without making a significant loss.

If you do get 100% of your principal back, thanks to inflation it could be worth much less than the day you put it in. With fixed terms of up to six years, this can really eat into the worth of your money at the end of the term. Even with modest returns on the high-risk portion of your investment, you could end up with less than you could get from a standard savings account over that time.

Your principal can also be eaten away by the numerous charges involved in structured products. As well as a usual 4% fee, you could pay extra for administration, dealing, hedging and other hidden costs.

What about the prospect of high returns? Unfortunately, potential returns usually depend on complicated scenarios that are difficult to fully understand. Some high-profile banks have even been fined for misleading customers on structured products that have lost money or failed to deliver what was promised.

While structured products do insulate investors from the decline in the value of their high-risk underlying asset, they also limit how much you can benefit from growth. For example, you could have a capped maximum return, or a condition where you will only receive returns if growth meets a target or stays within a set range. This means you are effectively being sheltered from the downside and the upside at the same time. With some products, if your underlying asset grows above a certain level, the issuer may recall the investment before maturity; so your investment can be cancelled for being too successful!

Investors who want to dip their toe in the water of riskier assets without feeling too exposed may find structured products suitable. However, for some, the high fees and diluted returns make it preferable to invest in the underlying asset directly without restricting their return potential. Others may have no tolerance for risk at all.

The trick for any investor, whether for their investment portfolio or their pension funds, is to tread carefully and find the right balance of risk and reward to suit them. This needs to be based on an objective assessment of their risk profile along with their personal situation and aims.

Remember that if something sounds too good to be true, it probably is. Before you sign up to anything, make sure you fully understand all the implications of any investment by speaking to an experienced and regulated adviser. They will carry out a high level of due diligence and only recommend authorised funds tailored to your individual circumstances and appetite for risk.

All advice received from any Blevins Franks firm is personalised and provided in writing. This article, however, should not be construed as providing any personalised taxation and / or investment advice.

By Gavin Scott
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Gavin Scott, Senior Partner of Blevins Franks, has been advising expatriates on all aspects of their financial planning for more than 20 years. He has represented Blevins Franks in the Algarve since 2000. Gavin holds the Diploma for Financial Advisers. |

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