CMFAS M8A Key Notes
They are commonly backed only by the issuer’s promise to make good on the intended payouts. They are not equity securities, and holders of structured products are not entitled to share the issuer’s profits. The fact that the intended payouts from structured products may be based on equity price movements does not make them equity securities. Structured products are also referred to as hybrid products, because it is possible to mirror equity-like (or other asset classes) returns using a fixed income structure.
A bond provides regular interest payments and repayment of the par value of the bond at maturity. Aside from the bond-issuer’s credit risk, the bond-holder has certainty of the return from his bond investment.
Structured products can be created and marketed in different formats, called “wrappers”. The choice of wrapper depends on a number of factors, including:
- regulatory restriction on issuers (e.g. only banks can take deposits, and only insurance companies can issue insurance policies);
- the desired investment freedom (e.g. there are investment restrictions applicable to collective investment schemes);
- desired level of transparency (e.g. structured fund allows independent valuation with the Net Asset Value (NAV) published on a regular basis);
- the targeted level of returns (e.g. some format is costlier than others); and
- tax consideration in a particular jurisdiction.
The most common wrappers are:
(a) Structured Deposits
(b) Structured Notes
(c) Structured Funds
(d) Structured Investment-linked Life Insurance Policies (ILPs)
- Lower administrative cost as the bank structuring the product also performs the distribution.
- The bank usually guarantees return of capital.
- Returns are lower (in general) owing to the cost of providing return of capital.
- Investors are unsecured creditors of the issuer in the event of liquidation.
- Full flexibility in product design.
- Investors are unsecured creditors of the issuer in the event of liquidation.
- Prospectus is required, resulting in higher issuing cost.
- A wide and ready distribution network through existing fund distribution channels.
- In a trust structure, there is greater transparency
of charges and investment performance. The trustee also acts in the investors’ best interest.
- In a trust structure, assets are held in trust for the benefit of the investors.
- Administrative cost is higher due to operating cost of the fund.
- Prospectus is required, resulting in higher issuing cost.
- Product design may be affected by investment restrictions due to regulatory requirements.
- A wide and ready distribution network through existing insurance distribution channels.
- Insurance coverage being provided, albeit typically very small.
- Insurers typically outsource the structuring, which adds an additional layer of cost.
- Similar to funds, investment restrictions may apply.
Structured products can be used as an alternative to a direct investment in traditional asset classes, especially in markets where direct access is restricted.
Structured products can offer access to exotic asset classes typically out of reach for individual investors. They are extremely versatile, and can be tailor-made to deliver specific risk / return profile to suit the investor’s needs, such as leveraged returns, guaranteed return of capital, or conditional capital protection.
Structured products can be used as part of the asset allocation process to reduce risk exposure of a portfolio.
Investment banks typically can issue structured products quickly, enabling investors to swiftly respond to market trends.
There are two components in every investment transaction, namely the principal invested, and the investment return generated. The return of principal is achieved through a fixed income instrument, which provides periodic interest payments (if a coupon-bearing instrument is used) and the return of principal on maturity. The investment return is delivered through a derivative instrument, which provides additional return based on the price performance of the underlying assets, namely equities, fixed income, currencies, or commodities. The underlying assets can be a single security, or a mixture of securities, depending on the investment target.
Structured products are by nature not homogeneous – as a large number of derivatives and underlying can be used. However, the more popular ones can be classified into the categories as described below.
- Interest rate-linked: Structured product designed to be linked to interest rates such as Libor or Euribor.
- Equity-linked: It refers to an investment instrument that combines the characteristics of a zero, or low coupon bond or note with a return component, based on the performance of a single equity security, a basket of equity securities, or an equity index.
- FX (Foreign Exchange) and Commodity-linked: This involves an investment instrument linked to the performance of a specific commodity, a basket of commodities, some foreign exchange rate, or a basket of foreign exchange rates.
- Hybrid-linked: It is a structured note, sometimes called “hybrid debt”. It is an intermediate term debt security, whose interest payments are determined by some type of formula tied to the movement of an interest rate, stock, stock index, commodity, or currency.
- Credit-linked: A form of funded credit derivative. It is structured as a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors. The issuer is not obligated to repay the debt if a specified event occurs. This eliminates a third-party insurance provider.
- Market-linked: A structured product that is linked to a certain or a basket of market indices.
Investors are often attracted by high potential payout products. However, a structured product delivers return to investors only when the:
(a) anticipated market view is correct;
(b) strategy or structure to capture the market view is appropriate; and
(c) pricing on the structure is reasonable.
Some examples of this type of products include:
- Structured deposits;
- Equity or credit-linked notes, to the extent that the fixed income component of the product is structured to provide the return of capital; and
- Capital guaranteed funds.
In terms of structure, a reverse convertible bond consists of:
- a bond, providing the periodic interest payments (if any) and par value at maturity; and
- a written put option (i.e. the investor is selling a put option), providing the shares in lieu of par value at maturity if the kick-in level is breached.
- General Market Risk
Financial investments do not exist outside of the economy. They are affected by the general economic conditions and market outlook.
- Issuer-specific Risk
While general market risks affect the prices of all securities, there are risk factors that only affect the price of a particular issuer’s security. An obvious example is a downgrade in credit rating of a company, which creates downward pressure on the prices of its shares and bonds. This in turn causes certain derivative contracts based on that company’s shares or bonds to lose value.
The underlying assets (simply called “underlying” sometimes) of a derivative contract can be anything:
- weather (such as the number of days in a month that temperature is above or below a certain level);
- farm and agricultural outputs (such as soy bean, corn, pork belly);
- metals (such as gold, aluminium, palladium);
- energy (such as oil and gas); and
- financials – both physical (such as equity, bond, currency) and intangible (such as equity index, bond index, interest rates).
- Futures and Forwards;
- Options and Warrants;
- Swaps; and
- Contract for Differences
- Standardised contracts traded on exchanges.
- Subject to margin requirements
- There are partial settlements of emerging gains / losses through daily mark-to-market1 process.
- Non-standardised contracts traded over the counter (OTC) between two parties.
- Not subject to margin requirements.
- Settlement of gains / losses only occurs on delivery date.
There are two basic types of assets for which futures contracts exist.
- commodity futures contracts (metal, grains, softs, energy); and
- financial futures contracts (Interest rates, bond prices, currency exchange rates).
Options and warrants are similar. Both give the right to buy (“call” contract) or sell (“put” contract) the underlying security:
- in specified quantity;
- at a specified price (called the “exercise price”, or “strike price”); and
- on or before a specified date (called the “expiry date”).
The value of option is based on a number of factors as follows:
- current spot price of the underlying asset;
- exercise price;
- time until expiry;
- interest rate;
- volatility of the underlying; and
- dividend rate on the underlying.
The common types of exotic options include:
- Asian option
- Forward-start option
- Compound Option
- Chooser Option
- Barrier Option
- Binary Option
- Rainbow Option
Unlike covered calls, where the call seller owns the underlying stock and can make delivery at a known price, the naked call seller is completely exposed to downside risk when the stock price goes up.
Selling naked calls is one of the riskiest strategies of all. Not only is the downside unlimited, the upside is limited to the premium received.
- Interest Rate Swaps
- Currency Swaps
- Credit Default Swap (CDS)
- Equity Swaps
- Commodity Swaps
A FoF is an investment fund that invests in other investment funds, instead of direct investments in securities. A FoF is also called a multimanager fund. The role of the manager of a FoF is to select the subfunds in which to invest, and monitor their performance to decide whether to replace non-performing funds. He also decides the allocation of investments into each sub-fund, within the parameters of the fund’s investment strategy.
The return-enhancement techniques include:
- the use of customised indexes, or dynamic instead of static indexes;
- the use of intelligent trading algorithms to generate value through trading, e.g. buying illiquid positions at a discount;
- the use of filters to eliminate index component securities that are likely to drag down performance, e.g. companies with excessive debt; and
- reduction of portfolio turnover by allowing funds to hold positions.
The relevant parties to a unit trust are as follows:
- Trust deed is the legal document for setting up the trust.
- Unit-holders are beneficiary owners of the trust assets;
- Trustee acts on behalf of unit-holders and oversees the proper operation of the trust, including ensuring that (i) the manager operates the trust in accordance with the trust deed, (ii) the investment manager directs investments according to the investment agreement, and (iii) legal compliance; and
- Manager performs the duties of day-to-day operation of the trust, including handling unit subscription and redemption, NAV determination, unit pricing, making investment decisions, preparing reports and accounts to the trustee, and pay expenses and taxes.
The trustee’s duties are to:
- protect the interests of unit-holders by ensuring that the fund is run in accordance with the trust deed, the regulations, and the prospectus;
- act as custodian for the trust assets, or to delegate this function to a third-party custodian. The trust assets are registered in the name of the trustee who also holds the trust income;
- create and maintain the register of unit-holders or delegate this function to the fund manager;
- replace the managers if they are deemed not to be acting in unitholders’ interests, become insolvent, or if the majority of unit-holders vote to remove them;
- send reports and accounts to the unit-holders, or delegate this function to the fund manager; and
- report any breaches to the MAS.
The fund manager’s operational duties are to:
- make payments to unit-holders who have redeemed their units, and other payments to entities providing services to the fund;
- prepare accounts and reports for unit-holders;
- keep records of instructions to the trustee on voting relating to the fund’s investments, and soft dollar commissions received;
- maintain a record of all soft dollars received;
- consult the trustee when there is a conflict of interest in exercising voting rights relating to the fund’s investments;
- give notice to the unit-holders on significant changes to the fund;
- obtain resolution of unit-holders for changes to the trust deed;
- conduct all transactions with or for the fund at arm’s length; and
- report of breaches of the investment guidelines to the MAS.
- Diversification: ETFs track the performance of a market index. Investing in ETF means that the investors are automatically diversified across the entire market.
- Low Cost: ETFs are passively managed. The fund management fees are lower than those for actively managed funds. Direct distribution cost is also lower as compared to unlisted funds.
- Reduced Tracking Error: Tracking error is the biggest disadvantage for index funds. However, by using swap agreements, synthetic ETFs can more precisely track the movement of the index.
- Access To More Exotic Markets: ETFs provide retail investors access to markets (traditionally accessible only to institutional investors) such as commodities, foreign equity markets, and non-deliverable currencies.
- Liquidity: Marketmakers provide intraday liquidity. Investors can buy and sell ETFs on the market every trading day just like trading stocks.
- Realtime Price Discovery: Price information is provided to the market in realtime. By comparison, unlisted fund prices are, at best, published once a day.
- Tracking Errors: Fund performance, as measured by the underlying index, is affected by tracking error. While the tracking errors may be minimised by using synthetic replication methods, there are still residual tracking errors, preventing the ETFs from fully replicating the performance of the indexes that they are designed to track.
- Counterparty Risk: The use of swap and derivative counterparties introduces additional counterparty risk for swap transaction involved.
- Expenses: The cost associated with using derivatives in a structured ETF contributes to tracking errors.
- Collateral Risk: In case of default of the swap counterparty, the value of the fund investments, e.g. basket of stocks held by the ETF under synthetic replication, may not be correlated to that of the underlying index tracked by the ETF. Thus, the collateral is commonly used to mitigate counterparty risk.