The bomb in the portfolios

Which investor can claim to know and be able to explain how “range target profit forwards” or “conditional target redemption forwards” work? There are probably very few, because experience shows that even among professional money managers, only a minority understand these products – many of them thanks to their specialised mathematical knowledge.

UBS’s wealthy clients have recently been the victims of such structured currency derivatives. By buying the above products, they are betting that the US dollar will move within a certain range. If this is the case, attractive returns await, although the amount is limited.

If, on the other hand, the dollar breaks through a predetermined reference rate, there is a risk of losses that can amount to several times the maximum achievable gains. Buyers’ risks are asymmetrically distributed, and it requires expertise to understand the potential gains and losses from all the possible price movements the dollar can take during the life of the product.

To make matters worse, the risks associated with certain products are leveraged and a margin call can be triggered. After US President Donald Trump announced a new tariff regime on 2 April, the dollar depreciated rapidly and broke through the lower reference rate of the structured products, causing owners to suffer devastating losses in some cases.

UBS clients subsequently claimed that they had not been adequately informed by their bankers about risks, leverage and the obligation to make additional contributions. Apparently, the bank also sold such products to inexperienced customers, which is why it is at least partially liable for the losses incurred.

Well understood and correctly applied, structured products have their uses. Thus, a Swiss industrial company can use a customised construct to make a targeted commitment to buy dollars at potentially lower exchange rates in order to pay for its future imports from the USA and at the same time generate additional income. Experienced investors use structured products to supplement their portfolios in specific market situations. Barrier Reverse Convertibles (BRC), which offer attractive rates of return, are particularly popular. Buyers of these products expect the prices of selected shares to move sideways, slightly higher or lower. If prices fall more sharply, BRCs offer the possibility of adding shares to the portfolio at lower prices via the built-in short put option.

One problem with BRC products, which are usually based on several shares, is that they function according to the worst-of principle. If the price falls below the barrier, the security with the worst price performance is delivered at maturity. The consequences are often underestimated by investors.

This is because many structured products contain the same or similar underlying assets, so that cluster risks arise in the portfolios during a bear market and when the price falls below the “knock-out barrier”. This had a devastating effect on the German payment service provider Wirecard.

The former “wunderkind” of the German Stock Exchange was a coveted object in the structured product sector due to its brilliant and volatile share price performance. There were 167 barrier products listed in Switzerland that used Wirecard as their underlying benchmark. When the company collapsed spectacularly in 2020 and filed for insolvency, numerous investors were left rubbing their eyes, as the barrier was broken in all structured products. As repayment, they received de facto worthless Wirecard shares.

In strong bear markets, structured products can potentially become fire accelerants in securities portfolios if several similar or even identical securities are flushed into a portfolio – this is the antithesis of the highly praised diversification in investments.

BRCs are often sold by banks as “yield optimisation products”. The example of Wirecard shows how misleading this term is. While the profit is limited to an above-average interest payment, a total loss of the structured product can occur in the event of the bankruptcy of a single share.

Many banks list structured products under the heading of “bonds”. This is confusing, because the risk of loss in bear markets is comparable with that of equities. If the necessary expert knowledge in dealing with structured securities is lacking, a supposedly conservative portfolio can mutate into a risky junk equity portfolio almost overnight during a significant stock market correction.

This happened during the financial crisis, when banks such as UBS fell like dominoes and their shares ended up in the portfolios of structured product holders with losses sometimes amounting to over 80%. In some cases, portfolios containing structured products resulted in higher risks or losses than if they had been invested in a pure but well-diversified equity portfolio.

Practice shows that securities portfolios containing structured products are difficult to assess in terms of the risks taken. Depending on the type of product and the market situation, they may be closer to bonds or equities. The counterparty risk that structured product holders often take should also not be underestimated.

If the issuing bank goes bankrupt, the product falls into a black hole – as happened with the American bank Lehman during the financial crisis. The investment legend Warren Buffett describes this nightmare as follows: “Only when the tide goes out do you realise who has been swimming naked.”

Anyone who buys shares has an investment horizon of at least eight to ten years. Buyers of structured products, by contrast, place bets for one year and trust themselves to make a market forecast for one, two or three shares over this short period.

Whether this makes sense from a portfolio strategy perspective is questionable at best. Another major drawback is the high cost of structured products, which is usually around 2%. This may be attractive for the product artists, but in the end it comes at the expense of the investors.

Some banks are aggressively selling high-margin structured products to their customers and regularly draw up internal lists of the most successful sellers of these products. This is offensive and leads to conflicts of interest for employees.

At the same time, banks protect themselves by enclosing extensive “instruction leaflets with risks and side effects” in the sales prospectus. But who has the time and inclination to read them? The “packaging artists” at the banks themselves should know how great the risks are of galloping off with structured products.

During the financial crisis, structured products such as ABS (asset-backed security), CDO (collateralised debt obligation) and MBS (mortgage-backed security) became their undoing. At the time, they allowed themselves to be outwitted by their own highly complex risk models and literally lost the overview. The average investor is definitely overwhelmed by the complexity of structured products and should keep his hands off them.