Investors, Beware When Determining Your Observation Frequency!
By Julien Dauges
One of the advantages of investing in structured products is the ability to customize your investment to suit your risk tolerance and investment choices. The combinations are almost limitless! If the investment banks can sell it, they can mix up just about any cocktail you can dream of. This customization element and the ability to deliver it in a single package can be beneficial to the investor if done correctly…
When NEBA Financial Solutions ask IFAs how frequent they want the coupons to be paid out – either monthly, quarterly, semi-annually or annually – our clients would prefer to invest in a structured note with “Monthly” observation because 1) they will receive higher chances of the note being autocalled early, 2) they will have more chances of receiving coupons (12 times) compared to quarterly (4 times) or semi-annually (2 times).
However, did you know that the frequency of the coupon paid influences the percentage of return you will receive? Of course, there must be trade-offs since adding a benefit one place must decrease the benefit somewhere else. As you no doubt know, there is no such thing as a “free lunch.”
In a structured note, the observation frequency determines the percentage of your return because there’s a risk involved to get the returns we desired.
What’s more alarming is that the percentage of return investors will receive from these potential “monthly income” is substantial!
To illustrate, let’s look at the following example on an Index-based Note below:
Here is a comparison of how different observations could affect the return:
On the exact same note with the same parameters, modifying the observations from monthly to quarterly, increased the returns by around 3% P.A. Over a 6-year period, investors could lose out on up to 24% by investing in a structured note with monthly observations compared to investing in a note with a quarterly observation.
Well, I’m glad you asked. If the clients’ goal is to receive a 10% return per annum, monthly observations would require more volatile underlying compared to investing in a 10% P.A note with quarterly observations. By putting more volatile indices in your note, the chance of breaching the coupon trigger is increased and you decrease your chances to receive coupon payments on each observation date. You will also increase your capital risk.
Investing in a basket of indices above is as similar as to investing in a high volatility equity note below:
This Equity Note also has a 10% P.A. coupon, an 85% Coupon Trigger and a 60% Protection Barrier with the same returns and same protection as the monthly Indices note above. However, there’s 68.21% rate of volatility on this underlying! To give you an idea, index stocks in general have in between 19-20% volatility rate.
The Bottom Line
When investing in a structured product, keep in mind that the percentage of return per annum offered on a quarterly, semi-annual or annual observations note are usually higher compared to a percentage of return offered in a monthly observation.
Ultimately, it all depends on your priority…
If you are a low risk investor, is it advisable to invest in a note with less frequent observation (quarterly or semi-annual observations) with safer indices rather than investing in a monthly observations note with more volatile indices.
If you prefer a regular monthly income and are willing to forgo the potential gain of maximum growth in your investment, choosing a note with monthly observation might just be your cup of tea.
Note: Based on the note above, there’s now less chances that the coupon trigger will be breached because the safer indices are less likely to drop below the coupon trigger than the previous indices. Capital Protection is also stronger.
Need help in choosing the right structured products for you to invest in? You can contact us at [email protected] anytime you like, we’d be more than happy to help you out!
Visit www.nebafinancialsolutions.com to see our Structured Products and UCITS Funds http://www.nebafinancialsolutions.com/Risk-Rated-Portfolio-DFM, http://www.nebafinancialsolutions.com/real-asset-fund