1

I'm looking at investment products offered by several banks in my area. Many of them follow the basic idea of capped risk/gain: the earnings and the losses are proportional to a certain index, but both are capped in some cases. For instance, there's a simplified example (tracking EURONEXT index with a 10 years period):

  • if the index growth exceeds 6%/year, the investor gets the capital with gains capped at 6%/year (that's 179% of the capital)
  • otherwise, if the index growth is less than 6%/year, the the investor gets the capital with gains proportional to actual index growth over 10 years.
  • otherwise, if the index falls by less than 50%, the investor gets their initial capital (so losses are capped at 0%).
  • otherwise, if the index falls by more than 50%, the investor bears a capital loss proportional to the index fall.

I understand that the bank essentially buys from me an insurance against a catastrophic market failure, but are they paying me the right price for it? E.g. how does this product compare to a pure uncapped investment in the same index?

There are alternative offers where the investor gets to bear small losses, but instead both the gains and the losses are capped at a certain level, e.g. 6% per year. Those seem to be safer at the first glance, but are they really?

Improve this question
1
  • 1
    The insurance company is buying insurance against a catastrophic market failure (puts) but it's not from you. It's for the security combination of shares and options that creates the underpinnings of the cap and protection (see my answer).
    – Bob Baerker
    Oct 22, 2019 at 13:24

1 Answer 1

Reset to default
1

I understand that the bank essentially buys from me an insurance against a catastrophic market failure, but are they paying me the right price for it? E.g. how does this product compare to a pure uncapped investment in the same index?

The easy part of your question to answer is that there is no comparison of this product to a pure uncapped investment in the same index. The two have vastly different R/R elements. As for paying you the right price, that requires a much more complex answer...

Structured products like these are based on complex option strategies. There are many variations. A common one in the US is a one year cap of 8% with no risk for the first 10% of price drop that year. The components are:

  • An out-of-the-money covered call component is responsible for the cap
  • An at-the-money long put is provides the protection of the principal, down to a certain value
  • An out-of-the-money short (funding) put is responsible for the level below which you begin to lose money

I've probably already lost you so let's look at the big picture. The provider (insurance company, bank, etc.) is providing 10% indemnification. If this was done by the investor on the SPY, for that same 8% cap, he could have 18% of protection per year. That's where the performance differs. With the provider's product, if the SPY were to drop 18%, the investor would lose 8% which the provider would keep. Indirect fees!

Another drawback with this type of investment is dividends (if the underlying pays them). Stock exchanges reduce share price by the exact amount of the dividend on the ex-dividend date. These structured products tend to ignore this and that's an additional barrier to profitability. IOW, with the SPY at 300 with a 1.85% annual dividend, over the course of the year, share price will be reduced by about $5.45. If your payout occurs one year from now above opening price, the SPY must appreciate $5.45 before you get into your profitability range. The provider is pocketing the dividends. Indirect fees!

Each structured product is different so you have to drill down in order to understand what is actually happening and that's not always an easy thing to do. The big picture is that there are no free lunches. The provider is offering you an investment product that underperforms the actual investment combination of shares and options.

This isn't some theoretical application for me. I use this strategy. I recently did one on a $103 stock for January of 2020. I'll collect one dividend of $1.00. If it drops no more than 17.5%, I'll pocket $185 (not much of a profit but it's not a loss). Below that, I'll lose $1 per share for every $1 the stock drops. My cap is at $110 where I'll earn the maximum of $6.85 or 6.6% which annualizes to 23.8%.

So to answer your main question, the provider is not paying you the right price for this investment. You only get that if you DIY.

Improve this answer
4
  • Actually, 6% cap with 50% loss coverage doesn't seem too bad compared to your example of 8% cap / 10% loss coverage, does it? I know that no product will beat doing the investment myself, I'm trying to understand how much of the profit I'm giving away for the convenience of letting someone else do it. My goal is not to get the absolute maximum profit possible, but to avoid accepting an outrageously bad deal, like giving away half of the profits for a comparable amount of risk.
    – Dmitry Grigoryev
    Oct 22, 2019 at 13:49
  • 1
    The R&R go hand in hand. If you want more reward, you take on more risk. So if I were to shift the reward down to 6% potential from 8%, I'd have lower risk. It's all relative. I can't analyze your product since I don't know the components and it would take some effort to figure them out. So let's stick to my SPY example. They keep the dividends. That's a minimum of 1.85% taken from you. The DIY in my example currently provides 18% indemnity so with 10% from provider, they're 'stealing' 8% from you if there's a collapse. That's potentially 10+ pct. Not pretty. Yours won't be very different.
    – Bob Baerker
    Oct 22, 2019 at 14:05
  • So, essentially your DIY investment has a 24% profit cap with 18% indemnify in case of a loss, while a canned product comes with 8% cap, 10% indemnification and a 1.85% of profits taken from you? That's not pretty indeed.
    – Dmitry Grigoryev
    Oct 22, 2019 at 14:55
  • No, you're mixing the data from my two examples. The DIY SPY has a one year cap of 8% with 18% indemnity and 1.85% of dividends taken away. The DIY $103 stock has 19.3% indemnity (17.5% plus the credit) with a 6.6% cap for 3+ months which annualizes to 23.8%.
    – Bob Baerker
    Oct 22, 2019 at 15:34

You must log in to answer this question.

Not the answer you're looking for? Browse other questions tagged .