That sounds paradoxical, but it’s true: factor certificates can effectively result in a total loss even if the certificate’s underlying asset has ultimately moved in the expected direction. Even minor fluctuations in the underlying asset lead to massive price losses for the certificate. BaFin knows from complaints it has received that consumers rarely understand this. It has now analysed their behaviour in a market survey, which showed that retail investors often hold factor certificates for more than one day, which is the holding period recommended by the issuer in the key information document. And that is why investors often suffer heavy losses.

What are factor certificates?

Factor certificates are bearer notes that replicate the daily change in the price of an underlying asset – such as shares, indices or commodity futures. However, the factor certificate multiplies the percentage price gain or loss of the underlying asset by a contractually defined factor: the leverage factor. In contrast to knock-out certificates or warrants, this leverage is not variable or dynamic, but constant. As a result, factor certificates participate disproportionately in the price performance of the underlying asset. Issuers regularly offer factor certificates with a leverage of up to 15.

As a rule, factor certificates have an unlimited duration (open-ended, see expert article “Nice name, nasty surprise” on BaFin’s website), although the issuer can normally terminate them with effect from the next trading day. Investors can bet on a rising or falling underlying asset price (see question “What are long and short certificates?“).

Issuers certainly use different methods to calculate the value of the factor certificate. In many cases, for example, it is not the share, index or future that is the direct underlying, but rather a factor index, also known as a strategy index. The issuer itself calculates this index on the basis of a formula specified in the legal documents (see info box).

What is the upside of factor certificates?

Because of the leverage effect, a factor certificate allows investors to participate disproportionately in the performance of the underlying asset. In theory, there is no limit to any potential profits. A condition for this, however, is that the price of the underlying asset moves almost continuously in the direction expected by the investor.

And where are the risks?

There is a downside to the prospect of high profits: the leverage effect can also lead to disproportionate losses. A total loss is possible even if the price of the underlying asset moves sideways.

This negative sideways yield is illustrated in Figure 1: if the underlying price of a long certificate rises from EUR 10 to EUR 11, this represents 10 per cent growth, or 80 per cent in the case of a leverage factor of 8. In other words, the price of the factor certificate rises from EUR 10 to EUR 18. On the following day, the price of the underlying falls from EUR 11 to EUR 10, equivalent to a loss of 9.1 per cent. Now, however, the leveraged loss of 72.8 per cent (for a factor of 8) is deducted from EUR 18, with the result that the factor certificate falls below the initial value of EUR 10 and lands at EUR 4.91. This calculation methodology means that the factor certificate with a leverage factor of 8 loses around 99 per cent of its value over the assumed holding period of 15 days. It would need a higher daily price increase to recover the losses incurred. Looking at days three and four, for example, the price of the underlying asset would have to rise not by 80 per cent, but by around 268 per cent, to return to the level of day two.

Especially with high leverage factors, it is therefore not normally possible to simply ride out any losses. This example also shows that the higher the leverage factor, the quicker the investor can suffer losses – the red line (factor of 8) falls more rapidly to zero than the yellow line (factor of 3). Comparable price movements can also frequently be observed on the financial markets.

Figure 1: Theoretical example of a negative sideways yield

BaFin

What are factor long and short certificates?

For certificates, “long” and “short” do not describe the holding period, but rather the price movement expected by the investor. Investors who expect the price of the underlying asset to increase and want to participate in those increases will buy a factor long certificate. Conversely, if they expect prices to fall, they will buy a factor short certificate. If the price of the underlying asset rises on day 4, as shown in Figure 2, the price of the long certificate will rise, whereas the price of the short certificate will fall.

Both variants cannot overcome the main drawback of factor certificates – negative sideways yield. In both cases, this results in losses when the reference price fluctuates around the initial value. In the example with a factor of 10, the factor long certificate suffers a loss of 5.5 per cent over the 15-day holding period, while the loss for the factor short certificate is 8 per cent.

Figure 2: Theoretical comparison of factor long and short certificates

BaFin

How long should investors hold factor certificates?

As mentioned above, issuers of factor certificates recommend a holding period of one day in their key information documents. This means that factor certificates are expressly not designed for a long-term investment strategy, but solely for short-term speculation.

In its market survey, BaFin found out that retail investors often hold factor certificates for several months, thereby suffering a total loss in many cases. Some investors even remain invested for years. The consequence of this is that the value of their certificate can only be measured in cents at the end. The average holding period is 43 calendar days. The study also indicates that retail investors prefer high leverage factors.

When they look at factor certificates, investors should consider that the downside of any negative sideways yield is magnified by the duration and the amount of the leverage factor.

What should investors pay attention to in factor certificates?

In conclusion: interested investors should be aware that factor certificates are only suitable for very short-term speculation, not for any long-term investment. It is no coincidence that the issuers themselves recommend a holding period of just one calendar day. Investors should also note that they will not normally be able to ride out their losses, and that the chances of their certificate recovering any price losses are extremely low. Another issue is that investors can even suffer losses in the long term if the price movement of the underlying asset is positive. That is why factor certificates are only suitable for very experienced investors who are aware of the risks involved.