I have been instinctively suspicious of structured products sold to the private investor for some time, chiefly because of the charges taken out by both the investment bank instigator of the product and the distributor.
In today’s news the Financial Conduct Authority (FCA), the regulatory successor to the Financial Services Authority, in terms of financial advice to the private investor, has fined Credit Suisse, instigator, and Yorkshire Building Society, distributor, for misleading promotion of a structured product or Cliquet; their crime was highlighting a maximum return which was extremely unlikely to occur.
This caused me to wonder:
- What returns this product would have achieved, given the strength of the stock market over recent years?
- What has the regulatory performance of the FCA been like since it took over from the Financial Services Authority?
It is not easy to find the original key features of the particular products which have provoked the FCA’s ire (marketed as variants of the term ‘Protected Capital Account’) but I have found reference, in August 2008, to a promotion of a YBS ‘ guaranteed’ six year product linked to the FTSE 100, which offered a minimum return of 32% and a maximum return, I think of 60% (or c.80% depending on whether the ‘sum of’ each quarter’s maximum 2.5% gain means adding up 24 lots of 2.5% (ie 60%) or whether you got gain on the gain so to speak, but I think the former).
The Magic of Compound Interest
Now, the thing about structured products is that they take advantage of the magic of compound interest to produce an attractive looking minimum return; 32% looks quite good except if you know that six year gilts in August 2008 were yielding 4.5% (guaranteed return of 30.4% without any investment bank risk) and that 6 year swap rates (a proxy for what a fixed rate bank account would yield) were 5.3% (or a compound return of 36.1%.)
The investment bank is able to offer the upside against this minimum (and this is particularly attractive for the bank when the volatility of the stockmarket is high) and generate its own profit and pay the distributor of the product anything up to 5%, by placing most of the money on a fixed deposit and by clever use of an option strategy, in this case probably involving selling a series of out of the money call options, among other things.
If you had invested in this product at the end of August 2008, what would you be about to receive?
According to our calculations if the FTSE 100 stays roughly where it is, you would get back no more than your capital plus minimum return of 32%, because the sum of the quarters when the market was up less those when it was down (with the cap of plus 2.5% and the floor of minus 2.5%) total only c. 19%, if we have understood the product properly. The variant of the product based on a 6% cap and floor every six months fares no better.
This compares with a capital return on the FTSE over the period of 21.7%, together with income of c. 24%, giving a total of 45.7%. Of course this was not guaranteed, but a simple asset allocation of 50% to gilts and 50% to the FTSE 100 would have still done better than the structured product and paid you a better return up to the point where the FTSE had fallen 12.7%, assuming no cut in dividends (although of course the BP dividend was cut for two years).
This is not to say structured products are always bad but the particular feature of this one of the cap and floor made it very unattractive, since as the FCA has pointed out the likelihood of achieving the maximum return was almost zero.
And what of the Regulator?
Well to be fair, it is early days; the FCA took over from the Financial Services Authority as regards private investors only on 1st April 2013; so most of the issues it has been dealing with pre-date its tenure.
One big bloomer was the uncertainty created in insurance company shares by its leak on policy towards annuities; the big test will come when or if it has to face up to financial advisers as regards disclosure of charging and the quality of advice.
Do you think the FCA is an improvement on the Financial Services Authority? And what are your experiences of Structured Products as a private investor?