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Structured products, the holy grail of investing?

February 23, 2014



By Nicos Cotsapas

Structured products (SPs) and structured notes (SNs) are heavily marketed to often-unsuspecting retail investors. There are currently 770 billion worth of SPs/SNs in Europe alone! They often represent a big weight for many retail portfolios, and in some cases they take 100 per cent of the asset allocation. Is this the best way forward or should you be worried?

First, for those who never heard of them in the past, SPs/SNs are products mainly designed by banks' financial engineers. They are designed in such a way as to have unique investment characteristics. For example they can give a fixed return if a security stays within a certain trading range, or double the return of a security up to a certain level, or pay a fixed coupon provided that a basket of securities stays above a certain level etc.

Below are some things you need to know about such products:

Many times investors have a false understanding of what they are buying. For example, some advisers tell their clients that a product is capital guaranteed, while in reality the initial capital is only conditionally protected. The product might not be as attractive as it looks.



Most (if not all) products include hidden fees which make their pricing unfair for the at-issue investor. Many times they are a perfect way for issuers (banks) to both borrow and make money from investors at the same time.



According to a report by ESMA, the European Securities and Markets Authority, on average, products are sold with a significant premium of 5.5 per cent to their intrinsic value. That is, one pays 105.50 for each 100 of product they are buying! Hardly a bargain.



They have become very fashionable among financial intermediaries as in many cases they receive healthy commission of between one and eight per cent for selling such products to retail investors. Of course, such commissions come out of the of the investor's pocket.



The dividends of the underlying securities reduce the actual protection. If for example one security has a dividend yield of four per cent, then after three years the impact that dividends will have on its price will be approximately 12 per cent. Then, a conditional protection of 40 per cent, say, is actually a conditional protection of 28 per cent.



The issuer's default risk is something that almost all investors forget about in some cases the investor can find a higher return than that of the product by just investing in the issuer's bonds, and thus achieve higher return for the same amount of risk.



Below is an extract from the "prices" page of a very well-known bank that issues many retail structured products. Most products had an issue price of 100:



As you can see, the average current price of the above products is not as good. In fact 80 per cent of the 147 products (that are outstanding from this bank), are under water if one was to sell today. This is not a coincidence financial engineers cannot create something out of nothing markets laws (risk free rates, equity risk premiums, options pricing etc) apply to structured products as well. Note that the above data might be "biased" in the sense that it excludes matured (and probably "successful") products.

The retail distribution chain is often quite deep (Bank Bank Rep/Agent Advisor), and each needs to make profits. At the end of this chain is the individual investor, who foots the total bill. If the markets do not perform, the investor will be disappointed.

Even if you are happy with the recent performance of your SPs, keep in mind that since the market bottom in 2009, markets are up by 150-170 per cent. Is your return anywhere close to this number? And keep in mind that when the market correction will eventually come, structured products might take all the downside so is the risk/reward in your favour?

It is not a coincidence that structured products are mainly sold to retail investors who don't have the know-how to understand what they are buying. Institutional investors are aware of the above "traps" and so they tend to avoid such products.

In fact the US and UK financial regulators (SEC & FCA), as well as multiple articles in the financial press have for years, been raising concerns about individual investors not understanding SPs.

It is worth mentioning that sometimes structured products can indeed be attractive, but mainly if they are bought in the secondary market (as all hidden fees are usually paid by the at-issue investors).

So, to answer our initial question: Are structured products the best way forward? Yes, if you are an issuer, intermediary or financial advisor. If not, then I wish you good luck, because you will need it.



Nicos Cotsapas is a partner of Cyprus-based Elgin AMC and Swiss-based Elgin Group LLC.

Opinions expressed in this article are those of the author and do not constitute financial advice in any way. Please visit www.elginamc.com for more information. If you would like further information on how Structured Products affect your portfolio, please send an email to info@elginamc.com or call 22-465104.

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Source: Cyprus Mail


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