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Cameron Passmore CIM, FMA, FCSI

Portfolio Manager

Benjamin Felix MBA, CFA, CFP

Associate Portfolio Manager
Contact
  • T613.237.5544 x 313
  • 1.800.230.5544
  • F613.237.5949
  • 265 Carling Avenue,
    8th Floor,
  • Ottawa, Ontario K1S 2E1

Structured Notes are Behaviourally Satisfying and Rationally Harmful

February 3, 2015 - 0 comments

A structured note/structured product/equity-linked note is a financial derivative with a return at maturity that is linked to some underlying asset or group of assets. The linked asset tends to be some stocks or a stock market index. Structured products are popular because they play to investors’ behavioural biases, and they are profitable for financial institutions. These products are notoriously complex.

The product is effectively an unsecured bond that limits exposure to losses while being positioned to take part in potential gains. Structured notes are the product of investor fear, and tend to become very popular in periods of market volatility when a high potential yield and a principle guarantee become very attractive. Research has shown that structured products have not gained popularity due to rational analysis by investors, but instead due to the associated behavioural factors that they play to.

These products tend to be marketed to retail investors who have a limited understanding of the products’ underlying structure; this is a problem that is exacerbated by an enormous lack of regulation around their selling and marketing practices.

The rational role of structured products for a retail investor is questionable at best when modern portfolio theory is consulted; an investor should be able to maximize utility for any desired risk-return characteristics using a mix between the market portfolio (broad market ETFs), and the risk-free asset (GICs or short-term fixed income).

The main problems that structured products pose for investors include mind-numbing complexity, a cap on upside potential, an upfront sales commission (the investment is immediately reduced by the amount of commission), lack of liquidity (there is a limited secondary market, unless sold at a deep discount), and the opportunity cost of not investing in a traditional low-cost, risk-appropriate portfolio over the same time period.

In any case, each structured note is very different. Due to their complexity, in-depth analysis and understanding must be applied in every case that they are to be considered – though they should likely not be considered by a rational investor.

By: Ben Felix with 0 comments.
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