First and foremost, structured products are investment products sold to retail investors usually by banks through bank relationships managers. Despite going by different names and advertised rates of return, financial products that fall under the category of structured products usually contain certain characteristics.
1. Difficulty in accessing how underlying assets performed
Money does not drop from the sky. Whatever you invest in, that product need to generate positive cash flows through some means and from somewhere else, usually from common financial assets of rental income from properties, mortgages, coupon payments from bonds or dividends from stocks.
It is difficult to access its probability of returns given its complex nature.
2. No market value when need to cash out before holding period ends and upside gains are usually limited regardless of how underlying assets performed but when underlying assets lose everything, you lose everything.
Despite all the intentions and planning, sometimes you just need the money before expected holding period ends. When it comes to properties, stocks and bonds, there is a market to cash out holdings in them. But for the case of structured products, cash out value depends on what the banks say.
This is precisely the reason why people can invest in more risky structured products rather than shares of publicly traded companies of equal risk. Or worse, invest in risky structured products when there are investments with similar returns for much lower risks.
Because they don’t see the value of their structured products keeping changing in market prices like stocks, they felt safe, however, what they owns may not be necessary better than stocks as at least for the case of stocks, one can participate in the every of the upside when the company does well while structured products can only participate in every of the downside as in when the underlying investment does not do well and investors lose everything.
3. Unclear risks
In the first place, it is unclear from most structured products how they generate returns; much less determine the probability of losing initial capital. In other words, there is difficulty in forecasting events. Although in general, no one has the crystal ball, but still you cannot possibly lend money to anyone unrelated to you and expect that he will pays back.
As a consequence of point 1, there is a risk that the underlying assets do not succeed in generating the required cash flows, or even worse, there is something happen that result in losing initial capital.
For stocks, you know you loss your whole capital if the whole company is involves in creative accounting and become bankrupt as a result like Enron. One can estimate the risk involved by looking at the financial statements.
For bonds, there are some other methods, other than credit ratings to access the risk of defaults. For properties and mortgages, there are other credits checking of persons behind the payments as well.
4. Usually higher risk for less than required returns
In other words, it is like lending $1000 to a person to gamble in casino, where he can win a 100% return on each bet but at the same time can lose everything. If he is lucky and wins, you still only get 5% returns from him but if he is unlucky, you lose every $1000.
When the risk is high, it is natural that the expected return is also high.
For structured products advertised as low risk, one can quote the words of Warren Buffett,
Managers thinking about accounting issues should never forget one of Abraham Lincoln’s favorite riddles: `How many legs does a dog have if you call his tail a leg?’ The answer: `Four, because calling a tail a leg does not make it a leg’.
Just calling something low risk does not mean it is really low risk. As millions of Lehman Brother Minibonds investors in Singapore and Hong Kong can attest to that.
