Trade of the month: investment strategies

The UK Financial Services Authority review of structured products has encouraged issuers to take a closer look at product design, with an eye to creating investments with an outcome that investors can understand. For example, Royal Bank of Scotland (RBS) has simultaneously issued three products in parallel that pay heed to differing investment views.

These views are tailored around risk appetite and a chosen view of the financial markets. But while these basic requirements are plain, there are often so many competing products in the market that identifying the one that suits an investor best can be difficult. Each product has its own characteristics which include parameters such as maturity, underlying asset, credit strength of the issuer, risk profile, maximum and minimum outcomes.

Royal Bank of Scotland has attempted to maintain consistency in as many of the parameters as it can to enable investors to make the simplest distinction between three investment strategies. All three products are capital protected, linked to the FTSE 100, five and a half years long and issued by RBS. The capital protection on offer is because the products are aimed at lower risk seeking investors: independent of the FTSE 100 performance, they aim to return full capital. However, the investor is taking five and a half years of RBS credit risk, which is a non-zero risk, the seriousness and appropriateness of which depends on the investor's view of issuer credit strength.

The low growth product pays 26.5% if the FTSE 100 finishes above 80% of its initial level; the medium growth product pays twice the increase in the index up to a maximum of 42.5%; and the high growth product pays 101% of the index rise uncapped. All three products take as their definition of FTSE 100 growth the monthly average of the index over the final year of the investment.

The low growth product has the lowest maximum payout of 26.5%, followed by the medium growth, which has a maximum of 42.5%; the high growth has no limit on returns.

The first simple assessment that should be made is a breakeven analysis, which seeks to identify the range of scenarios in which each product would return the most in different outcomes.

The low growth returns the most in a (modest) bear market and is the only one to show a positive return if the FTSE 100 finishes below its starting level. The return from the medium growth product is equal to the payoff of the low growth product when the index shows a growth of 13.25% because the double participation equals the fixed digital style payoff. The medium growth product continues to show greater returns until it reaches its cap, when the index rise is in excess of 21.25%. The high growth product has no limit on returns and will eventually overtake the medium growth product, which occurs at a market growth level of 42.08%.

This elementary analysis shows that it is possible to divide the range of index outcomes into four zones: the index falling by more than 20%, when all products just return capital; the zone between -20% and 13.25%, when the low growth product returns the highest; between 13.25% and 42.08%, when the medium growth product excels; and index growth in excess of 42.08%, when the high growth product returns the most.

Having identified the relative advantages of each outcome, investors can start to identify which product is most suitable based on their own market view. It is important not to rely simply on the labels put on by the issuer but to translate the products into different markets.

A full analysis should explore the probabilities of outcomes and the robustness of returns, and any methodology should be capable of comparisons across products that differ more widely than three examples.