STRUCTURED products have been gaining in popularity recently, if increased sales are anything to go by.

A typical product currently in the market is offering a return of 4.35 per cent per annum over five years so long as the FTSE 100 index does not fall by more than 40 per cent in that time.

This might be attractive to someone seeking a fixed income who is willing to take a punt on where the index will be, but structured products have had a chequered past.

Loading article content

This has been not so much because of their underlying nature but often because those invested in them did not fully understand what they were investing in or did not look any further than the headline rate.

The advantages of utilising structured products in a portfolio are that the usual negatives of investment such as market downside, volatility and poor fund management can be replaced with known credit risk, defined returns and clear capital protection barriers.

For example The Lowes 2017 Structured Products Maturity Report found that 89 per cent of all products maturing in 2016 generated positive returns, with 8.9 per cent returning capital only and 2.1 per cent (nine products of 427) returning a loss to investors’ original capital.

However, there is no such thing as a free lunch.

Whatever the product literature might say high returns equal high risk and a close analysis of the small print will usually highlight the fact that the product is riskier than the headline indicates.

Back testing is used widely as an indicator of the likely returns of a particular product, but products are often designed in such a way that back testing looks favourable.

Remember, the definition of back testing should really be “here are some numbers we made up”.

Therefore investors should consider the investment merit of the underlying investment as well as the pay-off profile.

For example, in the product mentioned above if the FTSE 100 index is down by more than 40 per cent your investment return will be equivalent to the index and you will lose more than 40 per cent of your capital.

So you had better be confident that the index will not have fallen that far at the end of the investment term.

In a perfect world risk and return are well correlated but in the case of structured products this is not always the case.

Investors also need to consider the credit quality of the product provider as it will be that institution - a bank or group of banks - that underwrites the return.

Investors in products backed by Lehman Brothers learnt this to their cost during the credit crunch when the bank went bust and they lost out.

These products are often very complex and the devil is in the detail.

Typical performance tests require the selected index to be higher at maturity than the initial reference level.

This test can be made more difficult by requiring that either two or more indices are higher at maturity or the selected index is higher throughout the last six weeks of the product.

Also, what often sounds like a beneficial feature of a structured product may in fact be a negative.

To give an example, many products use an average towards the end of their life. While this is likely to be advertised as a protection against stock market setbacks, careful consideration should be given to whether or not it provides positive or negative benefits.

The use of multiple indices also sounds like risk reducing diversification but for these products it may mean more chance for one of them to disappoint.

In addition some products that have a stated life of, say, five years might actually retain the client’s capital for longer - usually a month before and a month after the period capital is at risk.

Investors should check that either interest is being paid during these periods or make an adjustment to the annual rate of return.

And do not forget you are normally locked in for the full term.

David Thomson is chief investment officer at VWM Wealth.