Friday, November 10, 2006

High cost of structured product

Someone asked me, "Mr Tan, what is the underlying value and risk of a structured product? Why has it generally performed badly for the investors?"

Here is my answer:

1. The product arranger (also called the underwriter or issuer) designs the product to earn an attractive fee. Generally, they do not take any risk. Most of the risk is eventually shouldered by the investor.

2. The distributor (usually a few banks) earns an attractive commission to sell the product. They give a sales quota for their marketing officer to sell the product to their customers.

3. My guess is that the charges paid to the arranger and distributor could amount to 10% of your investment.

4. Usually, the investor shoulders most of the underlying risk of the investments. In some structure, a portion of the risk is transferred to another party, but it comes with a cost, which as to be paid to the counter-party that accepts the risk. The counter-party is usually a sophisticated financial institution that can price the risk to earn a big profit margin.

5. This complicated structure adds to the cost of the product. If a safe investment can earn 3% per year, the investor can earn slightly more than 15% for 5 years. After deudcting the cost (say 10%) on the structured product, the eventual return to the investor will be only 5% for 5 years (ie 1% a year). After investing for so many years, many people find that they get a poor return, from a low risk product.

6. Some investors did make a better return (say 10% to 15% for a few years) on structured product which carries a high risk. However, if they had invested in the shares directly, their return would have been much higher. For example, I earned a return of 60% on the ST Tracker Fund during the past three years.

Lesson: Do not pay the high cost of a structured product. It does NOT benefit the investor.

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