Tuesday, 10 May 2016

Keep it simple, stupid

Great article which serves as a warning in the Straits Times:

Retail investors, steer clear of complex structured notes

Some snippets:

The name of the product was a mouthful: Six-month, Singapore-dollar non-principal guaranteed autocallable fixed coupon note with memory autocall linked to three shares.

It carried a fixed coupon of 8.01 per cent a year, payable monthly provided that "events" that would trigger an early redemption had not occurred.

The events were tied to the performance of three United States-based technology stocks: Google, Intel and Oracle.

Here is how Memory Autocall worked: The investor would receive a coupon payout of 0.6675 per cent of the principal amount each month, for six months.

But should the three stocks close at or above their initial prices on certain set valuation dates, a knockout event is deemed to have occurred. This would lead to the termination of the note, as a result of which the investor would get back her principal plus the coupon for that month.

She would also get to keep the coupons paid out earlier.

The three stocks did not need to meet the initial price threshold at the same time for the knockout event to take place.

If this does not sound complicated enough, there was another scenario known as the knock-in event to consider.

This would occur should any of the stocks fall to 80.5 per cent or lower of their initial price on any given valuation dates.

On the final valuation date, should the closing price of the worst-performing stock stay below its initial price, the investor's principal would be used to purchase the stock at the initial price. Under this scenario, a loss of capital is guaranteed.

This was exactly what happened to my friend's investment.

From then on, the investment was doomed even as my friend continued to receive her monthly coupons, given there was little chance that Oracle could recover to the initial price in the remaining three months. On maturity, a back-of-the-envelope calculation showed that my friend had suffered a loss of about $29,000 even after factoring in the $8,010 in coupon payments she collected.

On top of that, she was left holding Oracle shares bought at a high price - an outcome that she had not bargained for. She is still debating whether to sell the shares or hold on for a better price.
It bears repeating what I said earlier: Structured products do not compensate investors enough for the risks they are assuming.

My friend lost almost 15 per cent of her capital chasing an investment that would have, under ideal conditions, earned her 4.005 per cent at best.

The lessons from the above story:

  • Keep it simple, don't go for too difficult constructions that are almost impossible to calculate
  • Always be aware of the commissions

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