I came across an article on accumulators this past Saturday. It is quite informative; I’ve included it here for the benefits of our readers. Also, our reader can find our article on accumulators at this link: http://www.hkfinancialnews.com/?p=89.
Great for bankers, but a crazy deal for investors Why equity accumulators got dubbed ‘kill you later’
South China Morning Post
25 January 2009
In the second in a series of articles by Alan Alanson, the Road Warrior takes a sceptical look at a notorious banking product sold in the city.
One of the most infamous financial products peddled in Hong Kong of late is the equity accumulator. This is because pretty much everyone who bought one in the past 18 months has lost loads of money, earning it the apt nickname of “kill you later”.
The equity accumulator enables an investor to “accumulate” stocks at a discount to the market. If you were to purchase an accumulator today on China Mobile or ICBC stock, it would mean that you would start to purchase shares in these companies at about a 25 per cent discount to their trading price. If you were like me, when your banker pitched this product, you probably thought he was crazy to offer this deal. Turns out that you would be crazy to fall for it.
Buying stocks at a discount to the market sounds pretty good, but there is a little more to it. The first catch is that an accumulator is not a one-off transaction. It generally lasts 12 months and you have to commit at least US$1 million, with which you accumulate the stock regularly.
The next catch is that once you enter the accumulator, the price you pay for the stock is fixed. So the price you pay on the first day is the same as what you pay on the last day. If the traded price of the stock on day one is HK$100, you will pay something like HK$75. But if the price on the last day, or any other day over that one year, is HK$80, you will still pay HK$75 and only be getting a 6 per cent discount, not 25 per cent.
And of course, as everyone who bought this product last year now knows, if the stock price falls below HK$75, you end up paying more for the stock than it is worth.
There is another catch. If the stock price happens to rise more than about 4 or 5 per cent, the accumulator contract is over. The bank returns your money and you stop accumulating stocks at a discount. So although you take the risk of any fall in the stock price, no matter how great, the bank does not take the risk of any rise in the stock price. The bank takes the risk of only a 4 or 5 per cent rise and so limits its risk. The investor’s risk is unlimited; the bank’s is fixed.
Although you need to commit US$1 million, or HK$7.8 million, to be able to buy this product, to make our illustration simpler to follow let us assume the entry point is HK$1 million. So you commit your HK$1 million, say, to a China Mobile accumulator contract at a 25 per cent discount and the contract will be terminated if China Mobile rises 4 per cent.
We assume the stock is priced HK$100 the day you buy the accumulator. This would make your discounted purchase price, or strike price, HK$75. Since your HK$1 million is spread out over a year, you invest about HK$83,333 a month. So you buy about 1,111 shares every month at the strike price.
Now, three things can happen: the stock could rise, fall or stay relatively flat. With the accumulator, it is only in the last scenario that the investor really wins.
If the stock falls, the outcome is clear. If it falls by exactly 25 per cent, the return on your investment from then on is zero. If it falls more than 25 per cent (slips below HK$75), you begin to lose money.
If in the first month the stock begins to drop and the average price for the month is HK$90, your profit for the month will be about HK$16,700. If it continues to fall by HK$10 a month for the next two months, your profit will be HK$5,600 for the next month and then a loss of HK$5,600 for the third month.
If it drops to HK$60 in the fourth month and stays around there for the rest of the contract, you will lose about HK$16,700 a month until your 12 months are up, leaving you down for the year by something like HK$133,000.
The actual numbers would be slightly different as the stock purchases would be made only on trading days, and that varies from month to month, but you get the picture.
Now, if the stock stays basically flat for the 12 months, the potential profit is huge. If it stays at around HK$100, the investor stands to make about HK$330,000. But how often does any stock stay flat for more than a week, let alone a year?
The third scenario is that the stock rises. If it rises more than 4 per cent, the contract is over. If the stock price happens to be slightly less than the HK$104 threshold for a month before it rises to the point that the contract is terminated, the investor would make about HK$32,000 for the month (buying the 1,111 shares at a discount of HK$29). Now, that does not sound too bad. The investor makes HK$32,000, gets all his capital back after one month and is free to buy another accumulator.
But that return is 3.2 per cent, as the investor had to commit HK$1 million to make this HK$32,000. In committing that HK$1 million, the investor assumed the risk that the stock could fall by any amount and he would still bear all the losses.
And once again, bear in mind that the upside is limited and the downside is unlimited.
You might make a whole lot of money if the market stays flat for 12 months. But it is more likely you will make a small amount if the market rises, or lose a whole lot if it falls.
There is an even riskier version of the accumulator out there. Some banks refer to it as a leveraged accumulator. In this product, everything is the same except the initial discount that you get is substantially larger, about 35 per cent rather than 25. But if the stock falls below the discounted price, you must buy double the amount of stock you would buy if the stock price was above the discounted price.
This version has the same fixed upside, but doubles the downside.
And if that is not scary enough, there is one last twist, something that seemed so generous last year but turned into a nightmare. Some private banks offering this product are prepared to do the trade for their clients without an upfront payment. So long as your account has 30 per cent of the accumulator cost, you can enter the accumulator without having to come up with the other 70 per cent. So if your bank balance is US$1 million, you can enter a US$3.33 million accumulator. This is great when the market is rising, as you multiply your profits. But if the market falls, you multiply your losses.
In the scenario above, where the share price falls and you end up losing HK$133,000, this would be a 13.3 per cent loss if the initial investment was HK$1 million. But if the initial investment was only HK$300,000, the HK$133,000 loss represents a 44 per cent loss. So you have not doubled, but tripled your losses!
Combine the leveraged accumulator with a 30 per cent investment amount and it is not hard to see how you could end up owing the bank money. Plenty of people took this risk last year and plenty of private banks made money selling this product to their (now substantially poorer) customers.
So weigh your risks and returns properly before you get into this one.
January 27th, 2009 | Tags: accumulator, I Kill You Later, South China Morning Post | Category: General Trends | Comments (2)
