Following on from last week's introduction to structured products/guaranteed products, I'll answer a few questions we have been asked by readers, namely, how transparent they are, what are the charges, and how risky they really are.

Structured products are as transparent as Wayne Rooney's contract negotiations. Unlike most investments where the value of your portfolio is simply a multiplication of the value of the shares you hold in a company or fund against its price, a structured contract operates by investing into complex derivatives alongside buying guarantees through counterparties. You are probably bored already, but persevere; these are sold by the bucket load to unsuspecting investors at banks as simple products.

From my conversations with readers, few investors have ever been explained the complexity of counterparty risk. A counterparty is the most important aspect to understand as they provide the capital return at the end of the term of the investment and any default will mean the customer is also not covered via the financial services compensation scheme - you would lose all your money. As most investors into structured contracts are risk averse, how can it be possible that they would be happy to have the risk that all their capital could disappear? One can only assume the true risk has not been explained to them.

The FSA now expects advice on structured investment products should be given in the knowledge that investment grade counterparties can fail, so financial advisers should individually be able to explain the potential for risk and the potential for loss on a counterparty. So how can they do that?

That’s the really complicated bit. There are a few options an adviser can use to achieve that but ascertaining the risk rating from standard and poors is one, as well as Moodys, and Fitch. Also, the adviser should understand the counterparty risk and understand the geographical implications of that counterparty risk.

Furthermore, an investor should also look at the credit default swap of the company providing the counterparty. A credit default swap is a good method of ascertaining risk and the changing risk. A credit default swap is a measure of the market's pricing of the institutional risk of the provider.

So for example, if the cost of insuring £100 debt of Lloyds was less than £100, they would be classed as a low risk of default. The cost of insuring £100 of Lloyd's debt is actually 177.82 (five years credit default swap (CDS)) so therein lies a tale. (1) HSBC's CDS at 74.53 tells a rather different story. So the worse your credit default swap, the higher the cost of servicing that debt, but of course the higher the risk to the investor of losing their entire capital.

Furthermore, a financial adviser should be looking very closely at which direction a credit default swap is moving. For example, the fact Abbey Santander's credit default swap is 136.45 today versus its 83.50 six months ago will tell you the market may have turned negative against it.

Now I know this is remarkably boring, but if an adviser is selling you this as a simple product, you can now see it is far from that.

However, and perhaps very worrying is that Investec is often quoted as a counterparty provider yet it does not have an assessable credit default swap or a standard and poors rating.

How are financial advisers therefore able to assess the potential risk of the structured product before an investor falls straight into it, eyes wide shut.

The charges are also a fascinating subject. Most products are sold with the ‘there is no explicit charge’ line which is true but not really representative of what investors will read into it. They will read it as no charge at all, but most of the charge is hidden in the returns you will receive or don’t receive. To be simple, if they have offered you 80% of the return of the stock market, where is the rest going? This is the easiest place for them to hide expensive profitable charges and there is no regulation in place yet to ensure this is clear to the customer. It is simply fascinating to believe they are allowed to get away with this.

For a free fact sheet on structured products / protected or guaranteed products call peter on 0845 230 9876, e-mail info@wwfp.net or take a look at our website www.wwfp.net.

The value of shares and investments can go down as well as up.

Source 1. Incapital