STRUCTURED products start with a good concept. They combine stocks and bonds to give a unique risk/return mix.

TNP PHOTO ILLUSTRATION: SIMON ANG

Fixed deposits pay just under 2 per cent and stocks earn about 10 per cent in the long-run.

You don't find many investments in the middle.

Structured products fill that void by offering returns in the 2 to 10 per cent range. It is just right for some investors.

From the issuer's point of view, they need a cheap and dependable source of financing.

Structured products provide it.

They may pay as little as 1 or 2 per cent per year AND lock in financing for 3, 5 or even 10 years.

The issuing banks love them.

The secret to their success has been to advertise high returns but pay low ones. For example, brochures might advertise '8 per cent after 3 months plus up to 7 per cent per year for the next 7 years'.

First, investors may not understand that the 8 per cent interest is merely a give-back of their own capital.

The issuer takes your money, returns 8 per cent and calls it 'an 8 per cent payout'.

It is easy to confuse with 'an 8 per cent return'.

Second, the 7 per cent annual yield is the top end of the range. Actual returns are likely to be lower.

Structured products come in two basic types: Guaranteed and non-guaranteed.

1) Guaranteed

These have low risks and returns. Some are like a unit trust since they disclose expense ratios and distribution costs. Others do not.

Either way, after subtracting costs, not much is left for investors. It's a problem.

I did a study which found government bonds with the same maturity pay as much as guaranteed funds.

Bonds come with a big advantage: Liquidity. You can sell them at any time without paying a huge 'early redemption' penalty.

2) Non-guaranteed

These are usually credit or equity-linked notes. The brochures suggest you can earn high returns of 5, 7 or even 10 per cent per year.

They usually require you to make a bet on the price of well-known stocks, called reference entities.

High Notes 5 - issued by DBS - required investors to bet that none of the reference entities would default.

One did - Lehman Brothers - so investors will likely lose their investment.

By including a few reference entities, it may look like the risk is spread out and diversified.

That's wrong. Only one entity needs to default to trigger a total loss, so including more entities increases rather than decreases risk. It is the opposite of diversification.

The issuer typically invests 90 per cent of your money in bonds and 10 per cent in options.

If the bet pays off, so does the option and you get the high end of returns.

Otherwise, the option expires worthless and you get the bond's return minus expenses and the cost of the options.

That doesn't leave much. At maturity, it is common to find that structured products have returned only 1 to 2 per cent per year.

The biggest drawback is non-transparent costs. Issuers embed the cost in the price of the structured product.

Investors cannot break it out and may even think it is zero since the issuer's charges are not mentioned in the brochure or prospectus.

Investors see only the net returns, after expenses.

The effect of these hidden charges is to push returns to the lower end of the advertised range.

The product might offer returns of 'up to 7 per cent per year for 5 years' but the expected returns - known only to the issuer - will be just 1 or 2 per cent.

The result is issuers get a cheap source of long-term financing.

So far this year, $100 billion of structured products have been issued worldwide.

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