What are Structured products or Structured Deposits?

Struc­tured prod­ucts include struc­tured invest­ments, struc­tured deposits, cap­i­tal guar­an­teed funds and cap­i­tal pro­tected funds. The word “struc­tured” is rarely used in the mar­ket­ing and they are usu­ally sold as unit trusts or ILPs (investment-linked prod­ucts). Most are dis­trib­uted mostly by banks although insur­ance com­pa­nies have recently entered the picture.

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”.  The newly devel­oped struc­tured prod­ucts appealed to the masses and had sim­i­lar­i­ties to gam­bling.  It works like this:  A struc­tured 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 two fea­tures make it sim­i­lar to a wager.

But like all games of chance it is excit­ing to try one’s 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 often “guar­an­teed” (as long as you ful­fill other con­di­tions like no early redemp­tion).  It appears to be an invest­ment with no risks and good upside poten­tial.  Not sur­pris­ingly, it has sold very well.

ONE-TIME CHARGES

If you buy a struc­tured prod­uct, it will almost cer­tainly be from a bank who are the “dis­trib­u­tors”. 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 the invest­ment.  It means if sold imme­di­ately after pur­chase, the investor would receive back 97 per cent of the investment.

The dis­tri­b­u­tion cost does not seem to be exces­sive and is revealed in the fund’s prospec­tus (but not the brochures or adver­tise­ments).  It is in line with ini­tial sales com­mis­sions of unit trusts and ILPs (investment-linked prod­ucts) which charge 2 to 5 per cent.

Dis­tri­b­u­tion costs are one-time costs.  If one holds the struc­tured prod­uct for a num­ber of years, the aver­age annual dis­tri­b­u­tion costs will be less than yearly fees.

The issuer will also include a charge in the price of the struc­tured prod­uct.  It is typ­i­cally embed­ded in the instan­ta­neous vari­ance component.

ANNUAL CHARGES

Issuers charge annual man­age­ment fees.  They also charge per­for­mance fees which can be very high as I will explain.

Issuers are the archi­tects who design the struc­tured prod­uct. They also invest the money which the dis­trib­u­tor (bank) col­lects and remits to them.  Issuers are also called guar­an­tors and underwriters.

Struc­tured prod­ucts usu­ally sells in units and are clas­si­fied as unit trusts.  In this case, the must dis­close the man­age­ment fees.

When not sold in units, the issuer will sub­tract its fees directly from the fund’s yield. In that case, there is no way to deter­mine the cost the issuer charges.

The man­age­ment fee may be higher than it appears, espe­cially for guar­an­teed funds which invest about 90 per cent of the fund into bonds.

In these cases, the man­age­ment fee may take a sub­stan­tial por­tion from an already low return.

The issuer might take a fixed 1 per cent per year when total returns are between 1 and 5 per cent.  It leaves only 0 to 4 per cent for the retail investor.

An exam­ple: When a guar­an­teed fund’s return is 3 per cent, an issuer that takes a 1 per cent man­age­ment fee is tak­ing 1/3 = 33 per cent of the total return.

EARNINGS CAP

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 quite high.

The high returns do not go to investors because returns are typ­i­cally capped. It means they can­not go above a cer­tain level.

An earn­ings cap is typ­i­cally mar­keted as a ben­e­fit to investors and is called an “early buy­out”.  This is not cor­rect. It is a draw­back.  The investor would have made more money if there were no earn­ings cap.

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 that over 2 years, you will have earned 11 per cent (3+3+5).

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 and the issuer needs to pay investors only 11 per cent.  In this case, the excess returns are even more. They are 26 – 11 = 15 per cent.  As before, none of the excess returns go to investors. The entire 15 per cent goes to the issuer.

Nearly all struc­tured prod­ucts con­tain caps. It is an upper limit to returns. It guar­an­tees that investors will not par­tic­i­pate in high returns when mar­kets are strong.  Instead investors will receive a mod­est bonus in the form of a buy­out.  (Usu­ally, it is 5 per cent.)

In a strong mar­ket, who gets the returns in excess of the cap?  For some struc­tured prod­ucts, it may go to the issuer.  For oth­ers, it may go to a coun­ter­party to a hedge contract.

Regard­less, the deriv­a­tive por­tion of the struc­tured prod­uct is a fair bet prior to charges.  If one party wins, the other loses.

As sec­ond level of analy­sis, one must under­stand that it becomes a negative-sum invest­ment. This hap­pens when one con­sid­ers fees of the issuer and distributor.

Those fees are found in (i) the issu­ing charge that is either (a) charged as a man­age­ment fee or (b) embed­ded in the prod­uct itself, (ii) the issuer’s prof­its from market-making, (iii) the front-end load charged by the dis­trib­u­tor and var­i­ous hid­den fees deducted directly from the yield of the struc­tured prod­uct — such as for­eign exchange con­ver­sion costs, gains or losses from for­eign cur­rency fluc­tu­a­tions, taxes deducted at source and bro­ker­age commissions.

5 PROBLEMS OF STRUCTURED PRODUCTS

The first prob­lem is that many struc­tured prod­ucts are not traded as unit trusts and do not show the man­age­ment fee.  Instead, issuers will embed their charges in the price of the prod­uct itself.  As such, it is not pos­si­ble to know how much you pay for it.

A sec­ond prob­lem is the return caps.  These limit returns when the prod­uct does well, such as in bull mar­kets. It lim­its the profit poten­tial.  It may be fair if the cap is part of the struc­tur­ing.  One could think of it as the price one pays for ben­e­fits of the struc­tured prod­uct.  Typ­i­cally, how­ever, those ben­e­fits are empha­sised while the return caps are downplayed.

A third prob­lem is illiq­uid­ity.  If the investor sells prior to the matu­rity date, usu­ally 5 years, he must pay a penalty.  This can result in get­ting back less than the ini­tial invest­ment, a loss.  Even when the prod­uct is actively traded, the issuer will typ­i­cally act as the market-maker.  It is another source of profit for the dis­trib­u­tor and another cost for the investor.

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

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

Some­times banks even send a let­ter con­grat­u­lat­ing you on receiv­ing a high pay­out. The tac­tic seems to be effec­tive and has spread.  It has also been 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 upper end of that range is likely.

In fact, there is no way to know 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.

HOW TO RECOGNISE A STRUCTURED PRODUCT

Very often, struc­tured prod­ucts are mar­keted as famil­iar and safe invest­ments: Either a unit trust or an investment-linked prod­uct (ILP).  Typ­i­cally, the word “struc­tured” is never used.  How to know if you are buy­ing an ordi­nary unit trust or ILP  — or a struc­tured product?

Usu­ally, the only way to tell is if the return is linked to some other event — like “no more than 3 stocks in a bas­ket of 20 declin­ing in price each year”.  Most struc­tured prod­ucts will also have a buy-out pro­vi­sion.  It allows the fund to buy you out if it is mov­ing in the right direction.

Most struc­tured prod­ucts also adver­tise high yields. But a part of the yield is often a return of your own investment.

Can struc­tured prod­ucts be sold under the CPF invest­ment scheme (CPFIS), which per­mits you to use your CPF money to buy an investment?

The answer is “yes”.  If the prod­uct is sold as a unit trust or ILP, then it is pos­si­ble that it could be sold under CPFIS.  Keep in mind, there­fore, that just because a fund is CPF-approved, doesn’t mean it is not a struc­tured product.

Adapted from: http://www.askdrmoney.com/Analysis_Structured_Explained.htm