Don't buy structured products

History

Structured investments, deposits and guaranteed funds are a popular investment, distributed mostly by banks.

In the 1990’s, they were a way for rich individuals and institutions to structure investments to get their preferred mix of risk, return, liquidity, income and capital gain. This was useful.

As issuers got good at structuring, they expanded to the mass market. But how to make a customised product for each and every small investor? It seemed impossible.

It didn’t take long to find a way to "customise for the masses". Issuers came up with something like a customised gambling product. The product might take 20 well-known stocks, for example, and let people place bets on which three would appreciate the most over 5 years.

The world’s best stock pickers and sports handicappers would be hard-pressed to guess the outcome. In addition, every structured product has an expiry date. These features make it more like a wager than an investment.

But like all games of chance it is exciting to try your luck. Plus it looks like the odds are structured in such a way to give you a big payout if you win.

Add to this a minimum return that is “guaranteed” (as long as you fulfill other conditions like no early redemption). It looks like an investment with no risks and good upside potential. Not surprisingly, it has sold like hotcakes.

Initial Sales Commission

Distributors are mostly banks. Their standard fee is 3 per cent of the amount invested. For example, a two-month marketing campaign that raises $100 million would produce $3 million in revenues for the bank.

This 3 per cent distribution charge is deducted from the net asset value (NAV) of your investment. It means if you sold immediately after purchase, you would receive back 97 per cent of your investment.

Ultimately, the sales commission reduces your yield. You don’t see the reduction, however, because you are shown only the net return.

In a way, this cost seems not so bad. It is revealed in the prospectus (but not the brochures or advertisements) and it is in line with initial sales commissions of unit trusts and ILPs (investment-linked products).

Issuers' Fees

Issuers and their fees are most important because they hit you yearly. In some circumstances, they can be very high, as I will explain.

Issuers are the architects who design the structured product. They are also the ones to invest your money, after the distributor (bank) sends it to them.

Issuers also go by the names guarantors and underwriters. They include not-so-well-known names like Lyxor and Barclays.

For investors, the first surprise is that it is NOT possible to know how much the issuer takes from returns. You won’t find it in the product’s brochure, prospectus or anywhere else. You can ask the issuer or the bank but they won’t tell you.

Their fee is like the management fee charged by unit trusts and ILPs. It is routinely disclosed by unit trusts and ILPs.

Of course, it is key information since the more the issuer takes, the less that is available for the retail investor. (That’s you.)

Issuers hit you twice with their invisible fees.

Their first fee is fixed. As an example, the issuer might take a fixed 2 per cent per year when total returns are between 2 and 6 per cent. It leaves just 0 to 4 per cent for the retail investor (you).

This 0 to 4 per cent net return is all you see. There is no way for you to determine that total returns are more.

In this example, the issuer’s fee of 2 per cent may not sound like much, but it is. Work it out and you will see it comes to between 33 and 100 per cent when the total yield is 2 to 6 per cent.

They Cap Your Earnings

The second (variable) commission can be even more. Let’s say the structured product is linked to stock returns and these perform well. Then the structured product will also do well. Returns could be very high.

The problem is the high returns do not go to you. Issuers have found a way to keep the excess returns for themselves.

They do this by capping the return on structured products. Returns in excess of the cap are automatically channeled to the issuer.

Even more preposterous is the way in which the cap is marketed. Although it is always a drawback, it is promoted as an additional benefit for investors.

Usually, it is phrased something like this: "Should your investment do well, then at the end of year 2 you will receive an early buyout with a 5 per cent bonus."

Scenario 1: Suppose the structured product does well enough to pay its promised maximum returns of 3 per cent in year one and 3 per cent in year two. At the end of year two, it pays the 5 per cent bonus. It means you have earned 11 per cent over 2 years.

Scenario 2: Take a case where the product earns 8 per cent in both years 1 and 2. The total is 16 per cent. You will still receive the pre-determined 11 per cent and no more. The excess profits of 5 per cent (16 – 11) go to the issuer. It is not shared with investors.

Scenario 3: Suppose it was a great year and stocks shot up 26 per cent. The cap is the same. The issuer needs to pay investors only 11 per cent. In this case, the issuer earns even more: A whopping return of 26 – 11 = 15 per cent. As before, none of the excess returns go to investors.

Nearly all structured products come with caps. It is an upper limit which guarantees that they, and not you, participate in high returns when markets are strong.

Once a boom has been confirmed, the products’ contracts are written such that you will be bought out and receive a modest bonus, like 5 per cent.

The other possibility is the market is flat or falls. Then, the issuer’s profits are still assured. As per the structuring agreement, the issuer will receive a guaranteed return.

Incredibly, there is no way to know how much it is. Of course, this is crucial information as it directly affects your returns.

If the issuer takes 10 per cent of all the profits, it means 90 per cent is left for you. That’s good.

But if the issuer takes half the profits, half is left for you. And if the issuer takes 70 per cent, only 30 per cent is left for you.

Which is it? All structured products are non-transparent on this point. None disclose how returns are split between the investor and the issuer. You won’t find it in the prospectus or anywhere else.

Banks could request issuers to disclose this vital information. They might even insist on it. They do neither.

It is probably in their interests not to. If the invisible charges of issuers were made known to investors, it would likely have a negative effect on sales.

Five Problems

First, non-transparency of the management fees is perhaps the most serious flaw of structured products.

Return caps are a second major drawback. They limit your returns substantially when the product does well, such as in bull markets.

A third problem is illiquidity. If you sell prior to the maturity date, usually 5 years, you must pay a penalty. This can result in your getting back less than your initial investment.

A fourth problem is the marketing. It is less than straight-forward and often suggests a higher payout than you really receive. For example, it may be promoted as paying out 5.5 per cent after 6 months. It works out to 11 per cent per year. That’s good. In fact, it is too good to be true.

The prospectus’ fine print always contains a confession (sometimes in hard-to-understand language) that the high return requires a payout from capital. It means the payout is not a return on your investment at all. The bank has simply given you back a part of your own investment and called it a “payout”.

Sometimes banks even send a letter congratulating you on receiving a high payout. The tactic seems to be effective. It has spread and is also used to promote bank deposits and endowment insurance policies.

A fifth problem is the bank's marketing strategy. It advertises a range of returns. Bank staff then suggest to customers that the high returns are more likely.

Actually, there is no way to know this since structured product returns are based on baskets of shares, bonds, stock indices or currencies. Forecasting the return to each component of the basket over a 5-year period is extremely difficult. You might even say it is impossible.