Are the risks from investments in structured products worth their potential returns?

Welcome to Finance and Fury, the Say What Wednesday edition. This week the question comes from Mina.

“I would love to get your view on Structured products like the ones being offered by sequoia. Is the risk worth the return?”

Great question – thanks Mina - this episode is not investment advice – general nature - Structured products –

A structured product – can also be referred to as a market-linked investment – they are a pre-packaged structured finance investment strategy based on an underlying asset This can be built around a range of assets – from a single security, a basket of securities, options, indices, commodities, debt issuance or foreign currencies – complex structure They are an investment product that is put together by a financial institution - usually by a bank or investment firm – pre-packaged exposure to one or more underlying assets typically contain an embedded over-the-counter derivative contract, such as an option or swap, and they are often blended with a bank deposit or government bond to provide capital guarantees Structured products are a fixed-term investment that typically lasts between 3 and 10 years – most of sequoias are 3 years With these investments - as the value of the basket of assets rises over the 3–10 year period - the probability of the target return rate being met once the investment reaches full maturity increases Massive range of different types of structured products – as they are designed to provide investors with a range of different pay-offs – Like most structured products – like managed funds - the payoffs depend on the performance of the underlying asset But have additional elements – some structured products aim to provide investors with capital protection - others seek to generate enhanced levels of income or growth through leveraged exposure to the underlying assets that make up the product – so the risks can be very small – or large depending on the type Two major categories of structured products - Structured deposits and structured investments Structured Deposits – can be thought of as a mixture of a savings account and an investment With these – the invested funds are protected and even if the value of the underlying stock market index falls - considered a lower-medium risk Structured Investments – more of a capital-at-risk accounts – but aim to provide a higher return than a Structured Deposit With this type of structured product there is the risk of losing money if the underlying assets fails to perform A few types of structured products include: Capital-guaranteed structured investments – blend a bank deposit with an option or a leveraged investment in the underlying asset ratio between the deposit and the risky asset may either be fixed or flexible - at maturity investors either receive their capital back or their capital plus a return depending on the performance of the underlying asset As with any derivative transaction, investors need to ensure that they fully understand all the costs and risks as well as how the returns are to be calculated.

Are they a good investment option?

They are complex investments – so you need to fully understand what you are getting yourself into Structured Products were subject to mis-selling scandals due to the sellers not fully understanding the product- one case with Lloyds Bank where it was claimed to have mislead their consumers with an impression of a highly likely return through Structured Products However - there is a chance you may not make any return at all What are the benefits - Structured Products can be good if you don’t want to risk all of your capital – Due to the structure – you can get ones that have the majority of your money set aside for protection Structured Products can offer a medium risk method of investing Major risk is that you lose on this investment if the counterparty or deposit taker becomes solvent. This is only if you invested in a Structured Deposit as Structured Investments are not protected in the same way Returns - Issuers normally pay returns on structured products once it reaches maturity – but can pay coupons (income) along the way Can be called a payoff - or returns – but the performance outcomes are contingent For example - if the underlying assets return "x," then the structured product pays out "y." Creates a situation where a structured products performance is closely related to traditional models of options pricing- known as being in the money or out of the money - although they may also contain other derivative categories such as swaps, forwards, and futures, as well as embedded features that include leveraged upside participation or downside buffers Looking at an example -Consider that CBA issues structured products in the form of a capital notes—each with a notional face value of $1,000 – structured product is actually a package that consists of two components: A zero-coupon bond and a call option on an underlying equity investments – like CBA shares or ETF that mimics the ASX. Call option gives the right but not obligation to buy the share investment in the future at a current price – so you win if the price goes up - and The maturity is three years. Although the pricing mechanisms that drive these values are complex, the underlying principle is fairly simple On the issue date, you pay the face amount of $1,000 to buy this product - This note is fully principal-protected, meaning you will get your $1,000 back at maturity no matter what happens to the underlying asset. This is accomplished via the zero-coupon bond accreting from its original issue discount to face value. For the performance component - the underlying asset is priced as a call option – this will have an intrinsic value at maturity in 3 years time - if its value on that date is higher than its value when issued – then you get more back in returns - if not - the option expires worthlessly and you get nothing in excess of your $1,000 return of principal

The risks - there is a chance that your Structured Product investment may provide no return – minus any fees  

They could even produce a loss when they mature - This could be due to inflation(negative real return) or unfortunate circumstances with your deposit taker. Your money is at the hands of your counterparty or deposit taker - if they become solvent, you lose your investment Counterparty risks with derivatives – can go bad – if this is with a firm that isn’t TBTF – i.e. a non-SIFI Also have higher costs – looking at some – sequoia – application fee of 1.1% to 2.2% and investment cost for the first 2 years of 8.6% for a lot of products

 

Look at some with sequoia - Many different types – go through some of these to look at how they work

JB Global Booster Series 1 - been designed to offer flexibility by offering investors exposure the to the performance of the Australian share market as measured by the S&P/ASX 200 as well as a compulsory Loan under which Investors borrow 100% of the Investment Amount It is a three-year investment in a structured product that aims to provide investors with the potential to benefit from the growth of the S&P/ASX 200 Price Return Index – but also has a Capital Protection component on the scheduled Maturity Date It has a variable Participation Rate – so you can choose how much exposure you want - with the potential for a maximum of 150% Has Two Coupons of a minimum 3.60% and maximum 9% of the Issue Price of your Investment Amount paid at the end of the first 2 years, depending on the performance of the Reference Asset A final uncapped Coupon paid at the maturity of the investment, depending on the performance of the Reference Asset 100% borrowing at interest rates of 7.55% p.a -Interest is required to be prepaid each year annually in advance. At the end of Year 1 and Year 2, the amount of the Coupon will be set-off against the Prepaid Interest and you get paid the difference If the Coupon is greater than the Prepaid Interest, you will not be required to make a payment and will instead receive the net amount of the Coupon less the Prepaid Interest If not- some capital is taken out Downsides - Your return (including any Coupon) is affected by the performance of the Dispersion of Reference Basket and whether this is greater than the Hurdle at Maturity – this is with the option – if you finish out of the money - There is no guarantee that the Reference Basket will perform well. There will be no Performance Coupons payable if the Dispersion of the Reference Basket is below the Hurdle at Maturity. There is no guarantee that the Units will generate returns in excess of the Prepaid Interest and Fees, during the Investment Term. Additionally, in the event of an Investor requested Issuer Buy-Back or an Early Maturity Event you will not receive a refund of your Prepaid Interest or Fees. Gains (and losses) may be magnified by the use of a 100% Loan But this Loan is a limited recourse Loan, so you will never be required to pay more than the Prepaid Interest Amount and Fees at Commencement. Looking back – ASX200 investment – in the JB Global Income and Equity Booster Series 1 has matured on 30 June 2014 Delivered total returns to investors of approximately 21.08% during the Investment Term - The minimum Participation Rate for both Series is 0% which means investors have no exposure to the relevant Reference Asset. What did the ASX200 do over this period – Accumulated index went from 32,841 to 48,015 – total return of 46% over that period If you take the price purely – it has done okay – but if you had invested into those assets and received the dividend – done better – of course the opposite could have been true – if the markets went down

Is the risk worth the return -

Due to their structures – you can have smaller levels of risk – or larger levels – Due to most having a capital guarantee component – loss from volatility can be reduced – however – counter party risks are involved Aim would be to ensure you do not ‘put all your eggs in one basket’ If you wanted to invest this way – select investments that are diversified over different providers – but also that use different counterparties and time horizons – maturities When it comes to investing – I like things that have higher levels of simplicity – The more complex the structure – the more you might be buying something that may have hidden elements that can go wrong Unlike other structures – here you have additional layers of counter party risks

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