Should private investors invest in structured products? Here is a general overview applicable to all with key data on the structured product finance in Switzerland.
The appeal of structured products
The low or even negative interest rate environment in Europe and beyond is encouraging investors to look for alternative investment solutions. Some are taking speculative positions (Gamestop, Crypto) and others are increasing their equity allocation beyond what a balanced portfolio would normally require.
Structured products offer an alternative to equities, with a pre-defined coupon and exposure to an underlying asset (usually listed on the stock market). Compared to the low yield of bonds, these coupons seem attractive, but it is crucial for the investor to understand the mechanism as the risks can be substantial compared to a non-stock market bond investment. In addition to the coupon received, the advantages for investors are the ability to hedge a sector with a single transaction. Another benefit of structured products are the limited downside risk for those who understand these products sufficiently and the choice for the investor to select the underlying assets – for example, the stocks linked with the structured products.
Switzerland is the largest market for structured products in Europe. The half-yearly turnover for 2021 amounts to CHF 175 bn, 14% below the record turnover for 2020. Turnover has therefore “returned to normal at a high level”, according to the Swiss Structured Products Association (SSPA). This amount corresponds to just under 3% of investments in paper securities and this share has remained stable over the past few years, as it has increased in the same proportion with the booming markets. The SIX Swiss Exchange reports that almost 900’000 transactions took place in 2020 and that the number of transactions involving small amounts of a few thousand francs has risen sharply, a sign that individual investors are increasingly interested in this type of investment.
The main types of structured products
There are various strategies for investing in structured products, for example, to profit from volatile or moderately declining stock prices or to bet disproportionately on a stock boom. The main approaches are as follows:
- Barrier products (Barrier Reverse Convertibles or BRCs) offer a coupon to the client who recovers his invested capital as long as the structured product does not fall below a certain limit (barrier) during the term of the certificate. BRCs remain the most popular products, and their share of total turnover has even increased (representing more than half (54%) of all structured products. The construction of the BRC leads the investor to buy the stock at an overvalued price when the stock price falls, since the investor sells a put option and thus promises the buyer of the option to buy the stock at a certain price (strike price) if the stock price falls below that value. An interest (coupon) compensates the investor to take this risk. The success of BRC could be due to the high valuation and limited volatility on the stock markets because barrier products are suitable if stock prices do not make big jumps, i.e. they do not experience a sharp rise or collapse. The coupon is more important than the dividend, and thanks to the barrier, moderate price declines are borne without damage.
- Next to barrier products, capital guarantee products offer the possibility to recover the protected part of the capital (and not the totality) that you would have invested, with a limited exposure to the stock market. You can thus exclude a total loss but you will only participate in a part of the gains in case of a stock price increase.
- Conversely, leveraged products allow you to exacerbate the gains (but also the losses) of the underlying securities: Volatility was not high recently but the high price level remained and leveraged products had a moderate turnover.
Risks of structured products
In addition to market risks and liquidity risks (the possibility of losing value from the underlying and not being to exit the product at a favorable price), investors have to consider the risks of bankruptcy and issuer default (counterparty risks). These materialized in losses in 2008 for investors in structured products issued by Lehman Brothers: Many investors had bought a product with a coupon as a substitute for bonds or cash. When the issuer went bankrupt, these products lost almost all their value, with no possibility for investors to recover a small part of their investment for several years. Today, many issuers use the stock exchange to ensure settlement and limit this issuer risk (such as with the SIX structured products). In another more recent example, volatile stocks such as Wirecard in a barrier product initially provided very attractive coupons. However, this volatility also increases the risk of a barrier breach. Shortly before Wirecard filed for bankruptcy, there were more than 150 barrier products in Switzerland using the German company’s shares as the underlying. With the breach of this barrier, the holders of these certificates received the Wirecard shares (worthless) at the end of the transaction.
Structured products vs derivatives
Compared to options strategies (naked puts or covered calls – for advanced investors) with a low-cost broker (such as Interactive Brokers or Degiro), the fees for a structured product are substantial. This means that the valuation of structured products comprises its intrinsic value and the facilitation commission (which is like a fee for providing you higher comfort). The risk/return profile is therefore less favorable and Guide Finances cannot recommend structured products because of these disadvantages, because this site only highlights the best possible components of a balanced portfolio.
Are structured products a good investment? Cautionary notes for private investors
In times of negative interest rates, structured products attract investors with comparatively higher returns. Nevertheless, there is also the threat of painful losses, which the investor can contain by reducing the level of coupons and not selecting too volatile or risky securities. In any case, due to its peculiarities and high costs, a structured product can be a complement to an overall portfolio and certainly not as a core investment, even if the coupons seem to be an interesting deposit.
One of the basic rules for investing money applies especially to structured products, which are relatively complex investments: Buy only what you understand, consider the magnitude of the risks (and potential losses) you will be taking, and read the terms and conditions (including the fine print).
Source: Press release, Swiss Structured Products Association (SSPA), 5.8.2021
Guide Finances 