Business

PETER McGAHAN: Structured kick out plans

Peter McGahan
Peter McGahan Peter McGahan

LAST week we covered the structured products, often marketed as capital protected. As you saw, they are extremely complex, and most advisers wouldn’t be able to understand them let alone an investor. Be careful.

Next is another structured product where you will often see the name ‘kick out’ next to it. It’s quite something that they market being kicked out of the stock market as a good thing.

Once again, they are marketed with words like ‘deposit’, giving the illusion of security. This one is the S&P500 kick-out deposit plan. The headline is 6.4 per cent return for each year the plan runs. A deposit with 6.4 per cent? You’re hooked, as most might be.

The reality to this ‘simple’ product is different. The plan offers to pay out 6.4 per cent per year for each year held if the closing point on any of their future dates is above the initial start level of the S&P500. The first closing point is three years ahead, meaning that it’s highly likely your plan will mature in three years, with 6.4 per cent per year. If the S&P is up 12 per cent or 1 per cent per year, you just receive 6.4 per cent.

What has to be understood, is that the ‘kick out option’ is there to protect the market maker, i.e. the product designer, not you. By creating exotic options you will never comprehend inside the product’s design, the product designer is protected from large market rises and caps your return. Also, these ‘kick out options’ are cheaper for the product designer than standard call options, so more background profit for them.

If the market trades sideways, you would just receive the return of your original capital subject to the solvency of the deposit taker. It is a six-year plan.

If you need to encash before the six years, or if there was a death and the executor needed to encash, the return could be a lot less.

Despite all the lovely ‘simple’ headlines, it’s still an over-the-counter option that cannot be traded on options exchanges, so your receipt on encashment is the value that an investment bank will give you for an illiquid trade that only they can buy. Not so simple eh? Google supply and demand to understand the price you might get for it.

If you really want to understand the true risks to these products, it will involve reading all the T&Cs of a deliberately dull prospectus in order to check for nasties. It’s not a good use of time. It’s a contrived product.

Expect to see more of them being created as currently we have high interest rates and low market volatility, and that’s the best breeding ground for the best market to design these products and for their returns. In any event, it’s illiquid, and in a sideways market you would mature with just your capital being returned.

The investor does not receive a fair enough return for that complete illiquidity, but either way, should you invest into something that not even this column will help you fully understand?

Such kick out plans are the equivalent of being told in advance that if a party is better than average at any point in the evening you will be asked to leave. And you get to go out into the rain and pay more to come back in.

Marketed like that (which is what they are), you wouldn’t bother would you?

:: Peter McGahan is chief executive of independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority. If you have an investment you would like reviewed, call Darren McKeever on 028 6863 2692 or email info@wwfp.net or visit us on www.wwfp.net