Structured notes are financial instruments that can seem attractive due to their potential for high returns and tailored investment strategies. However, they come with significant risks and drawbacks, especially for retail investors.

Understanding Structured Notes

Structured notes are debt securities issued by financial institutions, combining a bond with a derivative component. This combination allows them to offer customized payoffs based on the performance of an underlying asset, such as stocks, indices, commodities, or interest rates. While this can lead to potentially higher returns, it also introduces complexities and risks that are not always apparent to retail investors.

The Opaqueness of Structured Notes

One of the main issues with structured notes is their inherent opaqueness. Unlike straightforward investments like stocks or bonds, the value and performance of structured notes depend on the interplay of multiple components. This complexity can make it difficult for retail investors to fully understand the product, assess the risks, and predict the outcomes.

• Complex Terms and Conditions: Structured notes often come with intricate terms and conditions buried in lengthy prospectuses. Retail investors may struggle to grasp these details, leading to misunderstandings about the product’s risk and potential returns.
• Lack of Transparency: The pricing and valuation of structured notes are not always transparent. Financial institutions may use proprietary models to value these products, making it hard for investors to determine if they are getting a fair deal.

Default Provider Risk

Another significant risk associated with structured notes is the default provider risk. Since structured notes are debt obligations of the issuing bank or financial institution, their value depends on the issuer’s creditworthiness. If the issuer defaults, investors can lose some or all of their investment.

• Issuer Credit Risk: The financial health of the issuing institution is crucial. Retail investors might not always have the tools or expertise to assess this risk adequately. During times of financial instability, the risk of issuer default can increase, adding another layer of uncertainty.
• No Government Guarantee: Unlike bank deposits that may be insured by government schemes up to a certain limit, structured notes do not have such protections. If the issuing bank goes bankrupt, investors have little recourse.

Hidden Commissions and Fees

Hidden commissions and fees are another area of concern with structured notes. These costs can significantly erode the returns that investors receive, often without them being fully aware of the extent of these charges.

• High Embedded Costs: Structured notes can have high embedded costs, including issuance fees, distribution fees, and ongoing management fees. These costs are often not disclosed clearly, making it difficult for investors to understand the true cost of their investment.
• Conflict of Interest: Financial advisors and brokers who sell structured notes may receive substantial commissions, which can create conflicts of interest. They might recommend these products not because they are suitable for the investor, but because of the attractive commissions.