david.fm

In my latest CNBC appearance I have briefly discussed my views about the Obama housing plan. This is a very controversial topic as many Americans don't really think that is fair to pay for mistakes made by their irresponsible neighbor. True, many Americans paid and pay their mortgage on time so why should they be held accountable (and pay with their taxes) for the others ?

A very good explanation is given by Fed Chairman Ben Bernake:

As Bernake suggests that it is more important to solve the problem than play the blame game. Like it or not the economy will not improve unless the banking system regains its solidity and access to credit is re-established. This means solving the housing problem. Given the precarious situation and market volatility I do not see any major solution or development for 2009. If we are lucky we will start seeing signs of normality toward the end of this year and more likely during 2010.

Among the investments that likely to benefit from the end of the crisis there are commodities: Oil at 40-50$ is not sustainable and as soon as demand will pick up, so will the oil prices. Similarly industrial metals, particularly copper, will benefit from the economic rebound.

In terms of equities the best way to exploit this situation is through structured products that allow you to make money even if the underlying (e.g. Credit Suisse shares) loses a great deal of their value. This topic will be discussed extensively during our upcoming "Investment Management" MBA class but I would like to give you a quick example. In Switzerland there are thousands of structured products quoted on our structured products exchange aptly named scoach .

Here many readers are probably wondering: what are these structured products?

What are structured products?
Issuers market structured products as investment instruments whose repayment value is determined by the underlying shares, interest, currency or raw materials such as gold, crude oil, copper and sugar on which the products are based. A structured product is made up of a traditional investment (such as a bond) together with a derivative instrument. Derivatives are financial futures whose price is based on an underlying asset.

What advantages are there in investing in structured products?
Structured products provide investors with any risk profile and in any market scenario with an appropriate repayment profile that makes satisfactory yields possible in growing, sinking or sideways-moving markets. Structured product risk can be closely controlled. Solutions with capital protection suit risk-averse investors, while investors looking for high yields invest in leveraged products. What's important is that investors receive qualified advice in selecting an appropriate risk profile and that they have a clear understanding of how the product of their choice functions. Another investor advantage of structured products is easier access to new markets that in the past were open only to institutional investors, such as raw materials or growing economies. That's why by any measure, structured products are an innovative alternative to traditional forms of investment such as stocks and bonds. source SVSP

There are hundreds of high yield structured products on financials but for simplicity I would like to give you an example on an underlying we all know or heard of: Coca- Cola.

This structured investment certificate on Coca Cola will pay a 10% coupon in a year in any case. At the expiry date (one year from now) you will receive a) 100% of your capital in case that the barrier of 29.55$ per share is never touched during this investment year OR, in case that it touches, you will receive the shares as if you had invested in Coca Cola today (at a price of 42.84$).

In other words your risk profile here is in any case lower than investing directly on Coca-Cola shares. Why?
In case that Coca-Cola will drop 31% you will receive in any case a 10% coupon to reduce your losses and the relevant shares (hence you will only lose in any case whatever you would have lost with the shares and benefit from a 10% coupon).

In case that Coca-Cola will not touch the 29.55$ barrier you will receive 100% of your invested capital and of course the 10%. The full details on this
structured product are available here

How likely is for Coca-Cola to touch 29.55$ ?
Let's see:

View the full KO chart at Wikinvest

As you can see in the last 10 years Coca-Cola was nowhere close the 20$ range.
Sounds to good to be true? Of course there is a limitation. If Coca-Cola gains 20 - 30% or 100% (not very likely but... ) next year your profit will be always limited to the coupon - in this case 10% - no more.

Another important feature: this product is traded on the Scoach Swiss Exchange here you can see the latest quote. As Coca-Cola dropped in the last week it is now tradable at at 98.25% so you can gain, in addition to the 10%, an additional 1.75%. If the price of the underlying increases, so is the price of the structured product. In this system you can always sell or buy the certificate during its lifetime - without having to wait maturity. This is very similar to bonds that often change hands several times before reaching maturity.

Structured products play a very important role in every modern portfolio. For the risk averse there are even capital protection products that guarantee 100% of the invested capital in any case. As an example you can invest in a structured product linked to the Swiss Market Index (SMI) and if the market raises you will be gaining the same percentage of the market increase (with a cap of e.g. 14%). If the market drops you lose nothing.

please see page 7 / 13 of this PDF for 3 different scenario

This product has a duration of 3 years but is an important opportunity to participate in a market without losing a dime - regardless of the market performance. If you compare this with a fund the structured product is clearly a winner. The only limitation is that your maximum profit is capped, for example, to 14% per year. Still if you compare this with the fund that gives you no guarantee you can clearly understand how less profit. With this product if the market has an explosive rebound you can gain 48% in 3 years and lose nothing. In a more conservative scenario you can gain 6-7% per year with no risk of losing your principal.

We all know that mutual funds preach a longer investment horizon (10 years? more) but the crude reality is that many funds produced a negative overall result during the last 10 years. If you take last year alone your fund might have lost 50% of its value. To go even that fund has to increase by 100% ! - and you will just be even.

In the case of our EFG capital protected certificate we would have never lost 50%. Unfortunately many retail investors ignore many of the benefits presented by structured products or reject them all together thinking that are over-complicated.

Hopefully these two examples will bring some light in this dark corner of investing.

For the few German speaking readers you can review
my latest published article on Stocks that gives a few more examples on structured products.

For those attending, either in March or April, our Investment Management MBA residential elective, fear not- there will be plenty of time to exercise and understand how to reduce your risk and bring both modernity and risk control in your portfolio.

David