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Analysis of Structured Products

"Any fool can paint a picture, but it takes a wise man to be able to market it."

-- Samuel Butler

While each product is different, most fall into a few broad categories. Below are examples of common types of structured products.

Distributors: Great Eastern Life

Name of Product: "GreatLink Choice"

Ad Description: Picture of an emblem on the front of a car which says 4.9 per cent.

Type of Product: Structured Product (which is marketed as an investment-linked plan (ILP)).

The Bold Claim: "An impressive annual payout of 4.9% over 7 years and returns 100% of your principal invested at maturity."

The Facts: (i) In the product summary, GE Life contradicts this promise. It says, "There is no guarantee that any payout will be made..." It goes on to say, "The fund could also lose a substantial portion or all of its investment." The actual return, therefore, is not 4.9%. In fact, returns range from -100% (total loss) to 4.9%.

(ii) GE Life also claims GreatLink Choice is "a single-premium investment linked plan". This is true but it is also a structured product, made up of 121 bonds. Therefore, you cannot use CPF money to buy it as you can for other single-premium ILPs.

(iii) GreatLink Choice is structured such that there are no losses for a few "credit events" (such as missing an interest payment). If there are up to 18 credit events, then there is no loss and investors receive the 4.9% payout. After that, losses accumulate quickly.

If there are 19, 20 or 21 credit events, the structured product will lose 1/3, 2/3 and then 100 per cent of its value. The product summary explains the effects of up to 19 credit events and then stops. It does not show how one can lose 1/3, 2/3 and then 100 per cent of the investment. The GreatLink Choice brochure is even worse as it does not mention these losses.

(iv) The product summary also lists the 121 bonds but instead of showing their credit rating, it lists them as either senior or subordinated debt. This has little meaning as it is the S+P or Moody's credit rating that determines the bond's risk. For example, a senior bond could be AA rated or it could be a BB junk bond. Knowing a bond is "senior" reveals very little about its risk.

(v) As with nearly all structured products, the maximum return is capped. For GreatLink Choice's cap is 4.9 per cent. Returns in excess of the cap go to the issuer and/or distributor. Investors cannot earn more than the cap.

(vi) Of course, issuers don't work for free. But the investor never sees their charges since they are embedded in the product's structure, which reduces returns. How much are returns reduced? No one knows as issuers do not reveal these charges. Most investors don't even know they are paying them.

(vii) If GreatLink Choice suffers many defaults, like 21of the 121 bonds, you will lose your entire investment. Could it happen? Yes, in a prolonged recession. But in a serious economic downturn, interest rates will fall causing bond prices to rise. This will offset at least part of the default losses.

It provides a kind of automatic insurance against default losses. The cap on structured products, however, removes this automatic insurance thereby increasing the risks to this structured bond product vs. a straight bond fund.

(viii) Two similar GreatLink Choice structured products were launched in September and October 2005. Investors purchased a whopping $100 million in each tranche. How have they performed so far?

The GE Life web site shows that after one year, the price of each has fallen to 91 cents on the dollar. It means investors have suffered a loss of 9 per cent. (In dollar terms, it totals $18 million for both tranches.)

Distributors: Great Eastern Life

Name of Product: "GreatLink Choice"

Ad Description: Picture of an emblem on the front of a car which says 4.9 per cent.

Type of Product: Structured Product (which is marketed as an investment-linked plan (ILP)).

The Bold Claim: "An impressive annual payout of 4.9% over 7 years and returns 100% of your principal invested at maturity."

(viii) Two similar GreatLink Choice structured products were launched in September and October 2005. Investors purchased a whopping $100 million in each tranche. How have they performed so far?

Distributors: ABN-Amro, Maybank, OCBC, Phillip Capital, UOB Kay Hian, Kim Eng, DMG & Partners

Name of Product: "MiniBond Series 2"

Ad Description: Picture of a small fellow sitting comfortably on the shoulder of a huge statue

Type of Product: Structured Product

The Bold Claim: "Total returns over 5 3/4 years of over 28 %." (Source: Ads and product brochure.)

The Facts: (i) Returns are 4.88 % per year x 5.75 years = 28.07 %. These are the maximum returns. There is no capital protection. Default risk, however, is very low since the product is linked to the credit rating of six very large and creditworthy companies. Sales staff focus on the low default risk and make no mention of a second risk which is much higher: Interest rate risk.

(ii) If interest rates fall, the issuer has the right to call (buy back) the mini bonds after one year. In this case, you would receive your principal plus a bonus. The problem is if interest rates have dropped, you would be limited to reinvesting your proceeds at the prevailing (lower) interest rate.

(iii) For the rare customer who brings up this point, the sales staff counter it by saying that for recent offerings of similar products in Hong Kong, the bonds were not called. Of course, the HK dollar is pegged to the US dollar and US interest rates have been rising for the past 2 years. The interest rate environment is about to change. (In August 2006, the US Central Bank (the US Federal Reserve Bank) finally paused after a 2-year series of interest rate increases.)

(iv) The mini bonds' lock-in period is 5 3/4 years. You will lose if interest rates rise during this period. Should you wish to sell the bonds to take advantage of higher rates, you would have to sell them back to the issuer (since the mini bonds are not traded). The issuer would probably buy them back at less than par value. It means you would suffer a loss of principal.

Distributors: ABN-Amro, HL Finance, Prudential, RHB Bank, Standard Chartered Bank

Name of Product: "Income X Fund"

Ad Description: Picture of a treasure map and an "X". It says, "Spot the treasure."

Type of Product: Currency arbitrage fund

The Bold Claim: "9 % payout in the first year of inception of the fund."

The Facts: (i) A footnote explains that the payout may be made from the capital of the fund. It means the fund would be giving back part of your own investment and calling it a "payout".

(ii) The footnote also seems to qualify the promise of a 9 % first-year payout. It says, "Distribution are at the discretion of PAMS and there is no guarantee that any distribution will be made or that the frequency or amount of distributions as set out in the prospectus relating to the Fund will be met."

(iii) The sales charge is 5 per cent and the yearly management fee is 1.5 per cent.

(iv) The fund is unique as it relies on a currency arbitrage strategy called "carry income". It is the difference between the yields on two pairs of currencies. For example, the fund might borrow in Singapore dollars at 3 per cent, convert to US dollars which it invests at 5 per cent. The 2 per cent difference is called the "carry income".

The fund’s two other income sources are from speculative currency trades as well as interest earned while holding the speculative positions. It holds positions for less than 6 months.

(v) There exists some evidence in the finance literature that currency markets are not efficient. If so, the fund is in a unique position to capitalise on it through its "carry income" strategy.

(vi) Since the fund specialises in foreign currency trading, an important cost is for foreign currency conversion. Like all funds, however, it does not include currency conversion cost in its expense ratio. As such, it remains a "hidden expense". It is deducted directly from the fund's yield, making it impossible for investors to determine the amount of this expense.

Distributor: OCBC

Name of Product: "Allianz GI RCM Global Twin-Focus Fund"

Ad Description: A golf club hitting two golf balls

Type of Product: Option Income Fund

The Bold Claim: "Potential high payouts of 6.88 per cent per year distributed quarterly."

The Facts: (i) If profits are low, the 6.88 per cent yearly payouts may come from the fund and “will erode the capital of the fund.” In that case, the fund is simply returning part of your own capital to you. This is the meaning of the following footnote from the brochure and fact sheet: “The payouts may be funded by the Manager realising sufficient investments of the Fund to raise the total amount required for the payouts which will erode the capital of the fund.”

(ii) The initial sales charge is 5 per cent and the management fee is 1.6 per cent per year.

(iii) Option income funds, such as this, buy high dividend stocks and write (sell) call options on the stocks. This supposedly locks in the high dividend income with no risk. Unfortunately, it isn't foolproof. If the share price falls sharply, the stock holdings will suffer the full amount of the loss minus the income from writing the calls. Big market downturns occur infrequently -- but when they do, the losses can be substantial. The fund may reduce this risk by purchasing put options. But to to a degree, it works against its strategy of capturing the premium for writing calls since the put premium paid will offset some or all of the income from writing the calls.

(iv) Another drawback with writing calls is you agree to sell the shares at a fixed price. It means you lock out potential gains. (Gains in the shares will accrue to the counter-party which buys the calls.)

(v) To hedge against a large share decline, it is likely the fund would buy index put options instead of put options in the shares it holds. It is because put options in the specific shares may not be liquid or even available. This presents another problem: The index and the shares may not always move together. This introduces another source of gain or loss. It is called "basis risk".

Distributors: UOB

Name of Product: "Fortune 8"

Ad Description: Picture of two Chinese coins making the number 8

Type of Product: Capital Guaranteed Fund

The Bold Claim: "Total guaranteed payouts of 8 % in the first year."

The Facts: (i) The 8 % payout information is correct. As with all structured products, the return is linked to events which are very difficult to forecast. In this case, it is the performance of a basket of 20 stocks. If the stocks do not perform well, 8 % will be all that the investor will receive at the end of 5 years. In that case, the return would work out to about 1.6 % per year.

(ii) The sales charge is 3.75 per cent and the yearly expense ratio is 0.7 per cent. These costs are about average for a bond fund. The fund invests mostly in zero-coupon bonds. (A small portion of the fund is invested in options linked to the basket of 20 stocks.)

(iii) As with all structured products, the maximum return is capped. The bank has a "call option" which gives it the right to buy back your investment by paying you a 5 per cent bonus.

The brochure and the sales staff give the impression that you are fortunate if you receive this bonus. The opposite is true. You will receive the bonus only if the fund does exceptionally well in which case the issuer will buy you out. This limits your gain. Excess returns go to the issuer.

Distributors: DBS, POSB

Name of Product: "Celebration Capital Guaranteed Fund"

Ad Description: Picture of a proud fellow drinking a glass of red wine

Type of Product: Capital Guaranteed Fund

The Bold Claim: "Fixed payout of 5.5 %, 6 months after the inception date."

The Facts: (i) The payout information is correct. Many customers, however, may believe that a "5.5 % fixed payout after 6 months" means a "5.5 % 6-month return" (which is 11 % per year). This is not correct. To make this large payout in just 6 months, the fund dips into the its capital. It means the fund is giving back part of your own investment and calling it a "payout".

(ii) As with all structured products, the return is linked to events which are very difficult to forecast. In this case, "the fund is linked to 6 Asia-Pacific market indices" and their performance over a period of 4 years and 11 months.

(iii) As with all structured products, returns vary from a minimum to a maximum. This is a capital guaranteed fund and returns will not fall below zero. Bank sales staff may imply the maximum return is likely to be realised. In fact, they don't know and the prospectus does not give enough information to determine it.

(iv) Its annual charge is deducted upfront. It is 3.5 per cent which works out to about 0.7 per cent per year over the 4 years and 11 months of the fund. It assumes the fund is not called. (See point v.) If it is, the annual fee would be slightly more than double 0.7 per cent per year.

(v) As with all structured products, the maximum return is capped. The bank has a "call option" which gives it the right to buy back your investment by paying you a 5 per cent bonus.

Distributors: ABN-AMRO, Maybank, OCBC, Phillip, UOB Kay Hian

Name of Product: "Mini Bonds"

Ad Description: Picture of a small fellow sitting comfortably on the shoulder of a huge statue

Type of Product: Structured Product

The Bold Claim: "Total returns over 5 1/2 years of 22 %." (Source: Ads and product brochure.)

The Facts: (i) Returns are 4 % per year x 5.5 years = 22 %. These are the maximum returns. There is no capital protection. Default risk, however, is very low since the product is linked to the credit rating of six very large and creditworthy companies. Sales staff focus on the low default risk and make no mention of a second risk which is much higher: Interest rate risk.

(ii) If interest rates fall, the issuer has the right to call (buy back) the mini bonds after one year. In this case, you would receive your principal plus 4 per cent interest. The problem is if interest rates have dropped, you would be limited to reinvesting your proceeds at the prevailing (lower) interest rate.

(iii) For the rare customer who brings up this point, the sales staff counter it by saying that for recent offerings of similar products in Hong Kong, the bonds were not called. Of course, the HK dollar is pegged to the US dollar and US interest rates have been rising for the past 2 years. The interest rate environment is about to change. US Central Bank rate increases are due to pause soon.

(iv) The mini bonds' lock-in period is 5 1/2 years. You lose if interest rates rise during this period. Should you wish to sell the bonds to take advantage of higher rates, you would have to sell them back to the issuer (since the mini bonds are not traded). The issuer would probably buy them back at less than par value. It means you would suffer a loss of principal.

Distributor: OCBC

Name of Product: "Allianz GI Global High Payout Fund"

Ad Description: Two door knockers in the shape of the number 8

Type of Product: Option Income Fund

The Bold Claim: "Potential high payouts of 8 per cent per year distributed twice a year."

The Facts: (i) If profits are low, the 8 per cent yearly payouts may come from the fund and “will erode the capital of the fund.” In this case, the fund is simply returning part of your own capital to you. This is explained in a rather hard-to-understand footnote in the advertisements: “The payouts may be funded by the Manager realising sufficient investments of the Fund to raise the total amount required for the payouts which will erode the capital of the fund.”

(ii) The initial sales charge is 5 per cent and the management fee is 1.75 per cent per year.

(iii) Option income funds, such as this, buy high dividend stocks and write (sell) call options on the stocks. This supposedly locks in the high dividend income with no risk. Unfortunately, it isn't foolproof. If the share price falls sharply, the stock holdings will suffer the full amount of the loss minus the income from writing the calls. Big market downturns occur infrequently -- but when they do, the losses can be substantial. A way to mitigate this risk is to buy puts. (But that works against the strategy since the premium paid for the puts offsets the income from writing the calls.)

(iv) Another drawback of writing calls is you lock out any gains. (Stock gains accrue to the counter-party which purchased the calls.)

(v) It is likely that the fund would use index options to at least partially hedge against a large stock decline. It is because options in the specific shares may not be liquid or even available. This presents another problem: The index and the shares may not always move together and this introduces another source of gains or losses. This is called "basis risk".

Distributors: DBS, POSB

Name of Product: "DBS High Notes 2"

Ad Description: Picture of a lady looking lovingly at a string of pearls

Type of Product: Structured Product

The Bold Claim: "A potential return of 21.5 per cent over 5 years."

The Facts: (i) Return for years 1 to 5 are 3.5 % + 3.5 % + 3.5 % + 5 % + 5 % = 21.5 %. These are the maximum yearly returns.

(ii) The ad does not tell the minimum returns and, as with all structured products, the prospectus does not give enough information to know which is more likely -- the min or max return. Bank sales staff often imply that the maximum return is more likely. In fact, there is no way to know this.

(iii) As with all structured products, the maximum return is limited. The cap is 14 per cent over 3.5 years, which comes to 4 per cent per year. The ad and sales staff give the impression that you are fortunate if you receive this early payout. In fact, the opposite is true. You will receive an early payout only if the fund does exceptionally well. If that happens, the issuer will buy you out, thereby limiting your gain. The remainder of the extraordinary gain (often the bulk of it) goes to the issuer.

(iv) As with all structured products, the return is linked to products and events which are nearly impossible to forecast. In this case, "The performance of DBS High Notes 2 is linked to a basket of 8 international and regional banks, each with a minimum rating of A- by Standard and Poors".

Distributor: DBS, POSB

Name of Product: "Delights Account"

Ad Description: Picture of a wedding cake

Type of Product: Structured Product

The Bold Claim: "5.5 % fixed payout after 3 months."

The Facts: (i) The payout information is correct. Many customer, however, may believe that a "5.5 % fixed payout after 3 months" means a "5.5 % 3-month return" (which is 22 % per year). It does not. To make this large payout in a short time (3 months), the fund dips into the its capital . It means the fund is giving back part of your own investment and calling it a "payout".

(ii) As with all structured products, the return is linked to products and events which are very difficult to forecast. In this case, it is "linked to the movement of 18 shares" over a period of 4 years and 11 months.

(iii) As with all structured products, returns vary from a minimum to maximum. Bank sales staff may imply the maximum return is more likely. This is not correct. The prospectus does not give enough information to determine which is more likely. Worst of all, the prospectus also does not tell how much the issuer is charging you. This charge is embedded in the pricing and the returns.

(iv) As with all structured products, the maximum return is limited. After 1 year and 11 months, the bank may buy back product by paying a 5 per cent bonus. The ad and sales staff give the impression that you are fortunate if you receive this bonus. In fact, the opposite is true. You will receive it only if the fund does exceptionally well. If that happens, the issuer buys you out, thereby limiting your gain. The remainder of the gain (often the bulk of it) goes to the issuer.

Distributors: DBS, POSB

Product name: "Triple Happiness Fund"

Ad Description: Picture of Chinese characters

Product type: Structured Product

The Bold Claim: "A 6.5 per cent payout 6 months after inception date."

The Facts: (i) The payout information is correct. Many customer, however, may believe that a "6.5 per cent payout" means a "6.5 per cent 6-month return". It does not. To make this large payout in a short time (6 months), the fund dips into the fund's capital. It means it is simply giving back a part of your own investment and calling it a "payout".

(ii) As with all structured products, returns are not guaranteed but vary from a minimum to maximum. Sales staff often imply the maximum return is likely. This is not correct. In fact, the prospectus does not give enough information to determine which is more likely.

Distributor: Citibank

Product name: "DepositMax"

Product type: Structured Product

Bold Claim: "Returns of 2.7 to 6.2 per cent."

The Facts: These are not annual but "18-month returns". The annual returns are one-third less at 1.8 to 4.1 per cent.

Distributors: DBS, HSBC, Maybank, Standard Chartered

Product name: "Japan Blossom Fund"

Product type: Structured Product

Bold Claim: "Fixed annual payout of 4.8 per cent."

The Facts: The fixed payouts are not really fixed. It states in the prospectus as well as the footnotes of the newspaper advertisements, "They are subject to counter-party risk and are not guaranteed."

Distributor: UOB

Product name: "Income Star Fund"

Product type: Guaranteed Fund

Bold Claim: "5 per cent guaranteed payout."

The Facts: You receive 0 per cent in the first 18 months. It lowers the average yearly payout to less than 5 per cent over the holding period.

Footnotes: i) Products evaluated here go by the names structured products, structured investments, structured deposits, capital protected funds and capital guaranteed funds.

ii) Sources of information: Prospectuses, product summaries, fact sheets, benefit illustrations and interviews with sales staff.

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