Are structured products a good Investment for you? No, but the same can’t be said for your broker

Investors often ask, “Are structured products a good investment?”

The investment industry periodically comes up with new income investments that offer better yields than bonds or GICs, and seem reasonably secure. However, these so-called “Structured products” inevitably come with hidden risks.

How Mining Stocks make a difference Learn everything you need to know in 'The Complete Guide to Mining Stocks' for FREE from The Successful Investor. Best Canadian Mining Stocks TSX: Plus Gold Stocks, Canadian Diamond Mines and more.  I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

Learn about these types of structured products to protect your capital

One example of structured investments that are popular with brokers are index-linked GICs. Supposedly these investments give you the capital-appreciation potential of a stock coupled with the safety of a GIC. We say “supposedly” because the first half of that claim is simply untrue.

The link between the investment and the performance of the index is weak at best. It is generally based on a complex formula that is cleverly designed to water down the value of the investment—to make it nearly impossible for the investment to provide a substantial return. That way, the sponsoring institution can afford to limit your losses on the investment, and still make a profit on its own operations.

You probably won’t lose much money in an index-linked GIC—and they are certainly a better investment than, say, penny mines. You may actually make a modest gain after several years. However, that gain will fall short of offsetting the risk you were exposed to and/or you sacrifice in yield. The return you lose goes to provide underwriting profits for the institution that created the investment, plus commissions and possibly a trailer fee for the broker who sold it to you.

The problem is that the financial industry offers its salespeople incentives to give clients advice that may not be in the best interest of the client. Brokers simply have too many opportunities to sell their clients investment products, like index-linked GICs, options, new issues, tax shelters and so on, that are designed to generate income for the industry and the broker, rather than gains for the client.

Are structured products a good investment? Investing in gold as a structured product is a mistake you want to avoid

Brokers sell various structured products for investing in gold and other commodities, while supposedly limiting risk. Most participants will ultimately lose money in these investments, as well. Or they will make a poor return in relation to their risk.

The difference between structured products and investing directly in gold options or futures trades is that the losses won’t happen so quickly. However, more of the money you lose will flow into brokers’ fees and commissions, while you’ll typically lose less on the commodity investments themselves.

Instead of structured products, we believe it is better to stick with shares of gold-mining firms, instead of bullion, when investing in gold.

We feel that investing on the basis of price changes for gold in the form of bullion, instead of in shares of gold companies, is more of a gamble than an investment. These activities don’t earn income, but instead consume funds for storage fees, insurance and so on.

A far better way to profit from rising gold is by investing in the stocks of gold-mining companies. That way, you benefit from increases in the price of gold, and you give yourself the potential for capital gains and income. You also save on the higher brokerage fees and commissions associated with other types of commodity investments.

Even so, because of their volatile nature, we continue to recommend that for most investments in gold stocks should only make up a limited portion of your portfolio’s resources segment.

Are structured products a good investment for you when they involve split-share corporations?

Investing in split-share corporations is a good example of another structured financial product.

Split-share companies typically invest in a small portfolio of stocks, each with a focus on blue-chip shares, utilities, banks and so on. A split-share company then issues two classes of shares. Usually, the capital shares get all or most of the capital gains and losses, and the preferred shares get most of the dividend income.

We may like a lot of the stocks that a split share company holds—but our view is that it’s a rare investor who needs dividend income but not capital gains, or vice versa. We think you are better off investing directly in the underlying firms. That way you’ll avoid the yearly management fees and other costs.

We think split share companies just turn good investments into speculations. You get all the risk of an equity investment, but none of the long-term security of owning a stock. Avoid both classes of split shares.

Bonus tip: Our three-part Successful Investor approach will help guide your investment decisions

If you want to cut risk, our view is that the best way to do it is by following our three-part Successful Investor philosophy for investing:

1. Invest mainly in well-established, mostly dividend-paying companies;
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; Utilities);
3. Downplay or avoid stocks in the broker/media limelight.

Have you invested in any structured products that turned out to contribute positively to your portfolio?