Equity-Linked Investments: Understanding The Risks And Rewards

Equity-linked investments (ELIs) are complex, structured investment products that may involve derivatives. The investment return is directly linked to the performance of a single underlying equity or a basket of underlying equities, typically ranging from one to four. ELIs are not protected deposits and are not covered by the Deposit Protection Scheme in Hong Kong. They can be linked to stocks or exchange-traded funds (ETFs) listed on stock exchanges in Hong Kong, the US, and other markets. ELIs typically offer flexible tenors, ranging from a few months to a few years, and may include features such as partial capital protection, callable features, and airbag features. While ELIs can provide the potential for higher investment returns than traditional time deposits, they also carry the risk of losing part or all of the initial investment.

The potential for higher returns than traditional time deposits

Equity-linked investments (ELIs) are structured investment products where returns are directly linked to the performance of a single underlying equity or a basket of up to four underlying equities. ELIs are often short to medium-term investments that can provide higher potential yields than traditional time deposits.

The potential for higher returns in ELIs comes from the direct link to the performance of the underlying equities. The rate of return for ELIs is determined by the market performance of the named basket of equities, which can result in higher growth than fixed-rate deposits. While traditional time deposits offer a specified interest rate at the time of deposit, ELIs offer the potential for higher returns by tying the rate of return to the average market performance of the underlying equities. This means that if the underlying equities perform well, the investor can earn higher returns than those offered by traditional time deposits.

Additionally, ELIs offer flexibility in terms of tenor and product features, such as callable features, potential upside features, and airbag features. Investors can choose ELIs with different investment periods, ranging from 2 months to 3 years, to align with their investment goals. The callable feature allows investors to receive potential returns and their invested amount before the maturity date. The potential upside feature provides the opportunity for higher returns if the underlying equities perform well. The airbag feature offers some protection against losses by setting a minimum redemption level, typically ranging from 70% to 99.9% of the invested amount.

However, it is important to note that ELIs also come with higher risks. The potential for higher returns is accompanied by the possibility of losses if the underlying equities perform poorly. In the worst-case scenario, the stock price can drop to zero, resulting in a total loss of the initial investment. Therefore, investors should carefully consider their financial situation, investment experience, and objectives before investing in ELIs.

Principal protection and knock-in features

Equity-linked notes (ELNs) are a type of structured product whose return is linked to the performance of its underlying equity. They are typically short-term investments, usually held until maturity instead of being traded on the secondary market. ELNs are not equivalent to time deposits and are not protected by the Deposit Protection Scheme.

Principal protection is a common feature of ELNs. This means that the investor will be guaranteed to receive the original amount invested, with the potential for additional returns based on the performance of the linked equity. The interest component of ELNs is staked in equity options, and the final payout to investors will be the original principal plus the payoff on the equity options.

The principal protection feature of ELNs can be structured in different ways, offering either full or partial protection. Some ELNs are not capital-protected, meaning that investors could lose all of their investment. Others offer partial capital protection, where investors receive a percentage of their invested amount back, subject to a base redemption level. This level is usually specified as a percentage and can range from 70% to 99.9% of the invested amount.

In the case of full principal protection, ELNs are often referred to as principal protected notes (PPNs). PPNs guarantee the return of the principal by the issuer, in addition to any gains resulting from the formula based on the performance of the reference assets. However, it is important to note that any guarantee of principal protection is only as good as the financial strength of the company making that promise. If the issuer becomes insolvent or defaults, investors may lose their entire investment.

Knock-in features are also sometimes included in ELNs. A knock-in is triggered when the closing price is lower than the exercise price on the expiry date. In this case, the investor will receive either a physical or cash settlement, which may include the delivery of the worst-performing reference asset, a potential cash dividend amount, and/or the cash equivalent of the physical settlement amount.

Customisable terms

The tenor, or investment period, of an ELI can vary from 2 months to 3 years, with some banks offering tenors of up to 11 months. The callable feature allows investors to receive potential returns before the maturity date. The flexible tenor allows investors to choose an investment period that aligns with their financial goals and risk tolerance.

ELIs are also available in a range of currencies, including HKD, USD, AUD, EUR, and GBP. This flexibility allows investors to choose the currency that best suits their needs and preferences.

In addition to tenor and currency, investors can also customise other features of their ELIs. For example, the strike price, which is the price at which the underlying stock can be purchased at maturity, can be set by the investor. This allows investors to purchase the stock at their desired price.

The customisable terms of ELIs make them a versatile investment option that can be tailored to meet the specific needs and goals of individual investors. It is important for investors to carefully consider their financial situation, risk tolerance, and investment objectives before investing in ELIs and to seek advice from a financial professional if needed.

Risk of losing your entire investment

Equity-linked investments (ELIs) are structured investment products where the investment returns are linked to the performance of a single underlying equity or a basket of up to four underlying equities. ELIs are typically short to medium-term investments that may provide potential yield enhancement.

While ELIs can be a great way to enhance your investment returns, it's important to remember that they come with a certain level of risk. One of the biggest risks involved in equity-linked investments is the possibility of losing your entire investment. Here are some key points to consider:

• Market Risk: The stock market is inherently volatile, and stock prices can fluctuate rapidly due to economic conditions, political events, and company performance. A market downturn can result in significant losses for investors.
• Company-Specific Risk: Even the most successful companies can experience setbacks. Investing in a single company can be risky, and poor performance by that company can lead to losses.
• Liquidity Risk: This refers to the possibility of not being able to sell your shares when you need to. During market downturns, it may be challenging to find a buyer for your shares, resulting in a loss of value for your investment.
• Currency Risk: If you invest in foreign stocks, you are exposed to the risk of currency fluctuations. If the currency of the country you have invested in weakens, the value of your investment may decrease.
• Inflation Risk: Inflation can erode the value of your investment over time, especially if the inflation rate is high. This can result in a loss of purchasing power.
• Credit Risk: ELIs are general unsecured and unsubordinated contractual obligations. When investing in ELIs, you rely solely on the creditworthiness of the issuer. If the issuer becomes insolvent or defaults on its obligations, you could lose your entire investment.
• Early Termination: Some ELIs can be terminated early by the issuer according to the terms set out in the offering documents. In such cases, you may receive a nominal amount along with any accrued potential cash dividend amounts, which may be substantially less than your initial investment.
• Limited Market-Making Arrangements: ELIs are designed to be held until maturity. If you try to sell your ELIs before expiry, you may suffer a loss as the amount you receive may be significantly less than your initial investment.
• No Capital Protection: Some ELIs do not offer capital protection, which means that the full amount of your investment is at risk. In the worst-case scenario, you could lose all of your investment.
• Sector Risk: Investing heavily in one sector, such as technology or healthcare, can be risky. If that particular sector experiences a downturn, your portfolio could suffer significant losses.

It's important to remember that while these risks exist, they can be mitigated to some extent by conducting thorough research, diversifying your investments, and staying informed about market developments. Additionally, before making any investment decisions, it is crucial to carefully read the offering documents and seek independent professional advice if needed.

The need for a suitability assessment

Equity-linked investments (ELIs) are complex, structured investment products that carry a certain level of risk. As such, investors should exercise caution and ensure they understand the nature of the risks and the possible consequences. This is where a suitability assessment comes in—it is a critical step in ensuring investor protection and promoting fair dealings with customers.

A suitability assessment helps determine whether an investment product is appropriate for an investor's financial situation, investment experience, and investment objectives. It involves evaluating an investor's risk tolerance, financial circumstances, investment goals, and other relevant factors. By conducting a suitability assessment, intermediaries can ensure that the recommended investment products are suitable for the investor and safeguard their interests.

In the context of ELIs, a suitability assessment is particularly important due to the complex nature of these investments. ELIs are structured products that may involve derivatives, and their investment returns are linked to the performance of a single underlying equity or a basket of equities. While ELIs offer the potential for higher returns, they also carry the risk of significant losses. Therefore, it is crucial for investors to understand the risks involved and assess whether ELIs align with their investment profile.

The suitability assessment process typically involves gathering information about the investor's personal circumstances, such as age, financial situation, investment experience, risk tolerance, and investment objectives. This information is used to assess the investor's risk tolerance level and ensure that the recommended investment products match their risk profile. It is important to note that suitability assessments should be updated regularly, as an investor's personal circumstances and risk tolerance may change over time.

By conducting a thorough suitability assessment, intermediaries can help investors make informed decisions about ELIs and ensure that these investments are suitable for their specific needs and financial situation. This not only helps protect investors from unacceptable losses or very low returns but also ensures that intermediaries comply with regulatory obligations, such as the FINRA Rule 2111, which governs the obligations of advisors and brokers to ensure suitable investments for their clients.

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