Know pitfalls of structured notes

PUBLISHED : Sunday, 22 April, 2007, 12:00am
UPDATED : Sunday, 22 April, 2007, 12:00am

Most Hong Kong investors in structured notes are attracted to the products because they believe they will pay a higher rate of interest than bank deposits, and a disturbing number of investors wrongly presume their principal is automatically guaranteed.

The Securities and Futures Commission (SFC) found in a year-end survey of the market last year that few investors fully appreciated the downside risks that came with many retail structured notes - which, in worst-case scenarios, might pay no interest at all and leave them with a parcel of shares valued at below their original capital investment.

In its regular investment advisory column penned under the nom de plume of 'Dr Wise', the investor watchdog warned that investors in retail structured notes should therefore approach their selection of these products with three caveats in mind.

Read all offering documents - marketing materials do not have full information; understand that a note linked to a basket of shares is riskier than one linked to a single share; and beware of and prepared for the worst-case scenario.

The most striking findings of the survey were that 42 per cent of investors bought structured products primarily for higher interest rates than bank deposits of a similar term and for perceived higher returns compared with other investments (which attracted 28.5 per cent of investors), and that many purchased these products for capital preservation in the mistaken belief that their original principal sums invested would be automatically preserved. Almost half of those who invested in equity-linked products did not realise that with an equity-linked note they could receive stocks instead of cash if the price of the basket of shares on which the derivative note is written drops below the strike price on the valuation date.

And only about 11 per cent of investors in equity-linked, credit-linked or index-linked products recalled having received and read offering documents, and fully understood them.

Not very wise, according to the SFC. 'The notes market is more sophisticated nowadays and there are a variety of structures to suit different investment objectives and risk appetites,' the Dr Wise column noted in the wake of the survey findings.

Returns on equity-linked notes (the most popular product among Hong Kong investors) typically depended on the performance of the basket of underlying shares on which the notes were based.

In a bullish market, where investor sentiment was positive and expectations that the underlying shares would all end above the 'strike price' written into the contracts, there was little risk attached to the investment.

So long as the shares were all above their strike prices (usually a small discount to the prices at the time the contracts are written) on each of the predetermined dates written into the contracts, the investors would receive a predetermined rate of interest and all would be well, since the rates written into the contracts would be above the rates available on ordinary bank deposits.

What few investors understood, however, was that in the case of many of the products, if the closing price of any share in the basket is below its strike price, investors will receive shares in the worst performing company on maturity of the note, and that the value of these shares could be substantially lower than the amount originally invested.

The moral of the story? Read the prospectuses with care and quiz your investment adviser on the downside risks before deciding.