As a general rule, most structured products sold in Asia are some form of selling puts where the return is capped and the risk is unlimited.
While the overriding principal when buying structured products should be the view on the underlying security, an equally – if not more important – characteristic (in my opinion) is the risk exposure when buying any structured product.
Understanding the risk dynamics
Most investors use return rather than risk when deciding to invest in structured products; this can lead to dangerous results.
Don’t forget the stated or potential return is driven by the volatility of the underlying stock, which in fact is the risk you are taking on. So to get slightly higher returns, you are taking on significantly more risk.
If investors were to focus on risk when investing in structured products, they would be much better off. We have all experienced clients’ portfolios where they hold a large allocation in one stock which they inherited from a previous structured product gone wrong.
They then hold on to this underwater position until it is profitable once again (if ever). In the meantime, their portfolios are out of whack and they are sitting on a dead asset, for the lack of a better word.
This problem is magnified when the underlying is a single security; this is why I advocate structured products linked to ETFs only.
For example, if a Hong Kong-based investor wants to invest in a structured product and they have a choice between 2800.hk (HSI tracker fund) or 5.hk (HSBC, just for illustration purposes) both have similar returns but the risk and the impact on an investor’s portfolio is significantly different if and when things go wrong.
Usually, these structured products are leveraged so if they get put into the underlying shares it is generally a significant exposure within their portfolios. So If the investor gets put into 5.hk, the company-specific exposure and the risk within their portfolios is significantly greater than if they were put into the HSI tracker fund. If the market (2800 and 5) fell 20%, 30%, 40% or more, which security would you prefer to be holding – the ETF or the individual security?
To me, the answer is easy; you should always prefer a more diversified ETF over an individual company security any day, and the only reason we select the security is because of potential returns.
While I appreciate this approach may be difficult for most investors to follow, given that clients who buy structured products look at individual securities and prefer the potential of higher returns and focus less on risk management. They apply a gambling approach rather than an investment one. But for those that can be convinced, it is the more prudent path to follow.
I would also suggest the universe of ETFs available globally makes the choices and selection more interesting and dynamic. So it doesn’t have to be all boring and limited to one or two ETFs.
The ultimate risk for structured product buyer is when the market falls and you are left holding the underlying asset.
Before you buy, ask yourself, “am I happy to own the security at that level and what affect does it have on my portfolio” when (not if) I am put into that security? Focus on risk rather than the potential returns.
Contact Todd: firstname.lastname@example.org