Why Do Expat Investors Keep Losing Money in Structured Products?

Structured notes, or structured products, are often marketed to expat investors as a way to generate a fixed return from the stock market on a regular basis, even when markets aren’t rising.

On the surface, it can sound compelling… perhaps even too good to be true.

Let’s take a closer look at the reality.

What is a structured product?

A structured product is an investment where your return is linked to performance of one or more underlying assets such as company or stock market index.

The “structuring” is that the products looks to change the return profile potential of a investments, by either capping gains or losses, or turning what would normally be a variable return in to a fixed return.

There are many different types of structured products, with widely varying terms.

But I often find expat investors mostly own “autocall” structured products.

Why do structured products seem so attractive?

The marketing of structured products often focuses on their potential income.

For example, an investor might be shown a product offering a double-digit annualised coupon.

Compared with cash deposits or traditional bonds, that can look extremely attractive.

The problem is that the coupon isn’t free money. The investor is accepting a particular set of risks in exchange for that potential return.

For example, in many auto-calls structured notes, the investor accepts a fixed return, capping their upside, but also accepting exposure to the full downside losses beyond a certain point. The fixed coupon, isn’t guaranteed it’s just one potential outcome.

This creates an important asymmetry – your potential gain can is limited, while your potential loss can be very large.

Why can a high coupon be a warning sign?

A high potential return should make an investor ask:

“What risk am I taking to receive this return?”

Financial markets generally don’t offer high returns without requiring investors to accept additional risk somewhere else.

With structured products, that risk can be hidden behind the complexity of the product.

The investor may see:

8%, 10% or even 20% potential annual income
a defined investment term
an autocall feature
and apparently limited downside protection.

What can be less obvious is the economic trade-off being made.

If a product provider is willing to offer higher potential returns, it must be accompanies by higher potential losses.

This could either be the features of the product changing, or the unseen probability of outcomes shifting.

This is why yield should never be considered in isolation from the maximum potential loss.

How do structured product returns actually work?

Auto-call structured notes are by far the most common ones I see expat investors have.

They typically track 1-3 underling investments, and the performance is tied to the worst performing investment.

The returns can be split into 3 broad categories – rising markets, sideways markets, falling markets.

In a rising market:

If the underlying investments in your structured product increase in value, it will usually autocall.

This means you structured note matures an you will receive the semi-annual coupon payment, but nothing more.

This might sound like a success, but what has actually happened is you have limited your potential return.

Think of it this way, let’s say your structured product tracked Apple, Amazon and Meta. Offering you a 12% annual coupon.

All 3 stocks rise in value by 15% before the first observation date. Your product matures and pays you 6% (half the annual coupon).

But if you’d simply owned the stocks instead, you would have made 15%. Your returns are capped.

In falling markets:

Most structured notes have a “Protection Barrier“, this is perhaps a misleading term.

The protection barrier looks are the value of worst performing underlying asset. If the worst performing asset is above the protection barrier, the value of your original investment is protected, and you’ll get 100% back at maturity.

But there are limits to this protection.

For example, if you have a structured note with an 80% protection barrier. This doesn’t mean you could only lose 20%.

It means in the underlying assets fall by less than 20% you’re protected, but if they fall by more than 20% you are exposed to the full losses.

So in our example, if the underling assets declined by 30% breaching the protection barrier, the value of your investment would also decline by 30%.

Many structured products also have a “Coupon Barrier“, similar to a protection barrier, if the underlying falls below this barrier, no coupons are paid.

In a sideways market:

This is where structured products have the potential to really deliver.

If markets don’t rise, but instead move sideways or slightly decline, you keep receiving the coupon semi-annual payments.

So you could make money, whilst the market does nothing. Usually your original investment is protected against small declines too.

At maturity you could receive 100% of your money back, and the coupon payments until the maturity date.

The challenge, is most investors in structured products don’t really understand this is how they add value.

A peculiar investment strategy…

Structured products with payoffs defined in the way above, can be summarised easily.

If you want them to make money – you need to find structured products linked to companies (or markets) that won’t grow in value at all, but won’t fall in value too much either.

That sounds like a very strange way approach investing doesn’t it!

Since markets typically rise over time, you’d only want a very small part of your money in a investment that pays off if markets don’t rise.

Instead structured note investors often think they’re investing in the underlying investments, when they aren’t.

And that’s why it’s common to see investors in these products lose money.

The products themselves are neither good or bad, but I see them mis-used regularly.

I believe they’re too complex for most non-professional investors to understand, and they rarely add value beyond a traditional portfolio mix of stocks and bonds.

Is there a better alternative to structured notes?

In most cases, the answer is yes!

This is because with a structured product the outcomes are defined, but the probabilities of each outcome are not. They tell you what you might get, but not the likelihood of it happening.

Comparatively with a diversified stock market investment, we can use history as a guide. Whilst the returns are variable, we can understand the probabilities.

Let’s look at the chart below. It shows the annualised return of a global stock market index if you invested in a give year, and held for 5 years.

So if we take 1996 as an example, if you invested on the 1st January 1996 and held your investment until 31st December 2000, you averaged 11.4% per year.