Searching for a better return?

Rates of return available to savers today are generally dismal.  So many advisers are promoting ‘structured products’.  These use modern financial innovation, based on derivative securities, to enhance the returns from fixed interest products or to reduce the risks associated with equity investments.

The usual structure of these investments is that the issuer puts most of your money in a fixed interest investment and uses the balance – after paying commissions and costs – to buy an option or series of options from an investment bank.  In effect, you are making a bet with the balance of your funds on what happens to stock markets.  You could just do that yourself anyway.  Find a secure home for most of your savings and take some risk with the rest.  If you are tempted by one of these structured products you should ask yourself that question and review that alternative.

There are two kinds of risk in structured products.  The first is the risk that the issuer can’t pay.  Deposits up to £50,000 – soon to be increased – are secured by the Financial Services Compensation Scheme if the issuer fails.  But structured products may not be.No one worried much about this sort of risk until 2008, when it emerged that some of these structured products had been underwritten by Lehman, which defaulted: others came from banks which were only saved by government support.

The more serious risk is that the bet goes wrong. You need to look very careful at what is covered by words like ‘guaranteed’.  Some products do promise to repay your capital, although after five or six years your capital will be worth significantly less than it is now.  Such products don’t guarantee the return that you will earn, and that return might be nothing at all.  Other products guarantee the yield, but not the capital.  Some promise your money back unless there is a large fall in the value of shares.  You need to look very carefully at these.  What you are doing is insuring a bank against falling stock markets.  Is this something you really want to do?

There is an important lesson in thinking about risk here.  When you take out an insurance policy on your house, you don’t expect to claim;  but nevertheless, you think the insurance is a good deal.  Don’t judge a risk by the most likely outcome – if you step into the road without looking, you probably won’t be knocked down, but it is still a stupid thing to do.  I don’t personally think the stock market will fall by 50% in the next five years – but that doesn’t mean I’m willing to bet heavily against it happening.

Still, you might be willing to do this if the odds were good.  Are they?

I don’t know – and nor do you.  I’ve looked at the kind of calculations needed to put a value on the options contained in some of the products being sold today and they are complicated.  Really complicated – and I say this as someone who has made a living out of building these sorts of models.

People who work in the banks that issue these products make these calculations.  They are not as good at making such calculations as they think they are – that is what went so badly wrong for banks in 2008 – and I wouldn’t bet on them having got them right now either.  But you would have to be brave to bet against them.  They have done the sums – and they can;   you haven’t done these sums, and you can’t.  People who judge that bookmakers are fools generally find that they themselves are the fool.  Never invest in anything you don’t understand.

John Kay is a visiting Professor of Economics at the London School of Economics, a Fellow of St John’s College, Oxford. He is a Fellow of the British Academy, a Fellow of the Royal Society of Edinburgh, and a member of the Scottish Government’s Council of Economic Advisers. He is a director of several public companies and contributes a weekly column to the Financial Times. He is the author of many books, including The Truth about Markets (2003) and The Long and the Short of It: finance and investment for normally intelligent people who are not in the industry (2009) and his latest book, Obliquity was published by Profile Books in March 2010. Visit his web site at www.johnkay.com

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