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9:05 am - Tuesday January 24, 2017

The Problem With Structures – Risks and Hidden Costs

| Investing | Rating: 4.5
by Numan

Structured products have grown increasingly common among household investors as they are conceived as a safe investment with nothing but upsides. However, as consumers, we must ask ourselves: Are these structured products better then other forms of investment just because the principal is ensured at the end of the investment period? Isn’t this a cheap marketing trick?

Marketing is certainly involved here. Households prefer certainty and security. An investment that can’t lose always sounds great. But stop and consider an investment with 0% return – Isn’t that the same as losing?

Most structured products can be characterized by the following:
1. They offer protection of principle
2. They require a concession on interest paid
3. They offer enhanced returns which depend on performance
4. They charge management fees

Let’s have a look at an example. Say a structured product offers us twice the price increase of euro to dollar in 1 year. A nice return on investment is possible. However, if the euro-dollar exchange rate hasn’t changed we’ve lost 1 year’s worth of interest (not to mention management fees).

It is quite easy to synthetically construct structured products which will ensure protection of principal and possible upsides using derivatives or other financial assets. This of course requires more financial know-how and may be costly in terms of transaction costs. It is also easy to expose your portfolio to a certain financial asset or economic indicator by buying derivatives or a smaller portion which will eventually yield the same return. This saves on the expansive management fees charged by banks for these products.

What else should we pay careful attention to when buying structured products?

#1 Alternative loss
As we’ve seen alternative loss is real. Conceding risk free interest is a loss as any other. Many structured products require a term of investment of over 1 year and up to 3 or 5. Losing alternative interest on 3 years of investment can be quite painful.

#2 Investment Period
Another major drawback of structured products is that money invested can not be liquidated without fines. Investing in bonds, mutual funds, ETF’s or stocks guarantees the investor the possibility of selling the investment.

#3 The Terms of the Investment
How is the return calculated? Is the euro-dollar exchanged rates averaged over the month or quarter? Is it the last known exchange rate available? This may be more significant in stocks when price variations can be sharp.

#4 Complexity
Some structured products can be very complicated. Make sure you understand what you’re investing in.

After discussing the risks and problems let’s have a look at the cases when investing in structured products is more appropriate:

#1 You’re financial know-how is limited and you are looking to invest in complicated financial assets
If you want to invest in commodities, derivatives, exchange rates or other risky and complicated financial assets and lack the knowledge investing in structured products is more sound

#2 You just want a taste of risky investment
Investing a certain percent of your portfolio (up to 10% I’d say) for the “excitement”, so to speak, can be done by buying structured products.

#3 You want to expose your portfolio to a certain financial asset with little risk You have a hunch the dollar is going to come back big time and you know nothing of derivatives. Buy a structured product.

If you’ve decided to invest in structured products try and focus on financial assets where high risks and returns are involved. As the principle is protected investing in structured products which are based on very risky financial assets has a better chance of yielding higher returns.

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