NOTE: This risk information is provided to the client prior to the conclusion of the contract. As the contents of this risk disclosure are amended from time to time, in particular to comply with legal or other regulatory requirements, the most recent version of this risk disclosure is always available on the website of Scalable Capital GmbH.
As at: May 2022
An investment is generally the use of funds in investments, tangible assets or the like for the purpose of making a profit. In the present case, the investment in question is an investment in financial instruments. Risks are part of every investment. Every investor should therefore develop a basic understanding of the characteristics, functioning and risks of an investment. The aim of this document is to provide investors with such an understanding.
The aim of investment in financial instruments is to preserve or increase assets. The main difference between investing in securities and forms of savings such as savings accounts, cash deposit or fixed-term deposit accounts is the deliberate assumption of risks in order to take advantage of opportunities for returns. In the case of savings products, on the other hand, the amount paid in (nominal) is guaranteed, but the return is limited to the agreed interest rate.
Traditional savings products usually increase in value over time, i.e. through regular payments and interest income. The amount saved is not subject to fluctuations. However, this supposed security may only exist in the short or medium term. The assets can be gradually devalued by inflation. If the applicable interest rate is lower than inflation, the investor has to accept a loss of purchasing power and thus a financial loss. The longer the investment period, the greater the negative impact of inflation on the assets.
Investment in securities is intended to protect against this gradual loss of wealth by generating a return above the level of inflation. However, the investor must be prepared to bear the various risks of the investment.
In order to select an investment strategy and the corresponding investment instruments, it is important to be aware of the importance of the three basic pillars of investment, namely return, security and liquidity:
The objectives of return, security and liquidity are interrelated. An investment with high liquidity and high security does not usually offer high return. An investment with high return and relatively high security may be characterized by lower liquidity. An investment with high return and high liquidity usually has low security.
Investors must weigh these objectives against each other according to their individual preferences and financial and personal circumstances. Investors should be aware that an investment that promises to achieve all three objectives is usually "too good to be true".
For investment purposes, it is particularly important not only to know and take into account the risks of individual securities or asset classes, but also to understand the interaction of the various individual risks in the portfolio context.
Taking into account the targeted return, the portfolio risk should be optimally reduced by a suitable combination of investment instruments. This principle, i.e. the reduction of the risk of an investment through an appropriate portfolio composition, is referred to as spreading risk or diversification. The principle of diversification follows the principle of not "putting all your eggs in one basket". Investors spreading their investment over just a few assets, may be exposed to unnecessarily high risk. Appropriate diversification can reduce the risk of a portfolio not just to the average of the individual risks of the portfolio components, but usually below that level. The degree of risk reduction depends on how the prices of the portfolio components are correlated.
The correlation expresses the degree of dependence of the price development of the individual portfolio components to each other. In order to reduce the overall risk of the portfolio, investors should allocate their funds to investments that have as low or negative a correlation to each other as possible. This can be done by spreading investments across regions, sectors and asset classes, among other things. In this way, losses on individual investments can be partially offset by gains on other investments.
There are general risks associated with investing that are significant regardless of the particular asset class, the particular way in which securities are traded or the particular investment service provided. Some of these risks are described below.
The overall economic development of a national economy typically takes place in cycles, the phases of which can be divided into the sub-sections upswing, peak phase, downswing and trough phase. These economic cycles and the interventions by governments and central banks that are often associated with them can last for several years or decades and have a significant impact on the performance of various asset classes. Unfavourable economic phases can thus affect an investment over the long term.
The inflation risk describes the danger of suffering a financial loss due to the devaluation of money. If inflation - i.e. the positive change in the prices of goods and services - is higher than the nominal return on an investment, this results in a loss of purchasing power equal to the difference. In this case, one speaks of negative real interest rates.
The real rate of return can serve as a benchmark for a possible loss of purchasing power. If the nominal interest rate of an investment is 4 % over a certain period of time and inflation is 2 % over this period, this results in a real interest rate of +2 % per year. In the case of inflation of 5 %, the real return would only be -1 %, which would correspond to a loss of purchasing power of 1 % per year.
A state can influence the movement of capital and the transferability of its currency. If, for this reason, a debtor domiciled in such a state is unable to meet an obligation (on time) despite its own solvency, this is referred to as a country or transfer risk. An investor may suffer a financial loss as a result.
Reasons for such an influence on capital movements and the transferability of the currency can be, for example, a lack of foreign exchange, political and social events such as changes of government, strikes or foreign policy conflicts.
In the case of investments in a currency other than the investor's home currency, the return achieved does not depend exclusively on the nominal return on the investment in the foreign currency. It is also influenced by the development of the exchange rate of the foreign currency to the home currency. A financial loss may arise if the foreign currency in which the investment was made depreciates against the domestic currency. Conversely, the investor may benefit if the home currency depreciates. A currency risk exists not only in the case of cash investments in foreign currencies, but also in the case of investments in shares, bonds and other financial products which are quoted in a foreign currency or make distributions in a foreign currency.
Investments that can usually be bought and sold at short notice and whose buying and selling prices are close together are called liquid. For these investments, there are usually a sufficient number of buyers and sellers to ensure continuous and smooth trading. In the case of illiquid investments, on the other hand, or even during market phases in which there is insufficient liquidity, there is no guarantee that it will be possible to sell an investment at short notice and without a significant price discount. This can lead to asset losses if, for example, an investment can only be sold at a lower price.
The value of an investment may fluctuate over time. This applies in particular to the prices of securities. The so-called volatility is a measure of these fluctuations within a certain period of time. The higher the volatility of an investment, the greater the fluctuations in value (both upwards and downwards). A longer-term investment in the capital market counteracts short-term fluctuations insofar as short-term fluctuations in value become less relevant over a longer period of time.
Costs are often neglected as a risk factor of investments. However, overt and hidden costs are of crucial importance for investment success. For long-term investment success, it is essential to pay close attention to the costs of an investment.
Credit institutions and other financial- or securities services providers generally pass on transaction costs for the purchase and sale of securities to their clients and may also charge a commission for the execution of orders. In addition, banks, fund providers or other financial service providers or intermediaries usually charge so-called follow-up costs, such as costs for custody account management, management fees, initial charges or pay commissions, which are not readily apparent to the client. These costs should be included in the overall economic analysis: The higher the costs, the lower the effectively achievable return for the investor.
Income generated from investments is generally subject to tax and/or duties for the investor. Changes in the tax framework for investment income may lead to a change in the tax and duty burden. In the case of investments abroad, double taxation may also occur. Taxes and duties therefore reduce the effectively achievable return for the investor. In addition, tax policy decisions can have a positive or negative impact on the performance of the capital markets as a whole. If necessary, the investor should contact their tax authority or their tax advisor in order to clarify tax issues and reduce the associated risks.
Investors may be able to obtain additional funds for investment by borrowing additional funds with the aim of increasing the amount invested. This approach results in leverage of the capital invested and may lead to a significant increase in risk. In the event of a falling portfolio value, it may no longer be possible to service additional funding obligations of the loan or interest and redemption claims of the loan, which may result in the investor being forced to (partially) sell the portfolio. Private investors are therefore generally advised against loan-financed investments. As a rule, private investors should only use freely disposable capital for investments that are not required for current living expenses or to cover current liabilities.
Accurate information forms the basis for successful investment decisions. Wrong decisions can be made due to missing, incomplete or incorrect information as well as incorrect or delayed information transmission. For this reason, it may be appropriate under certain circumstances not to rely on a single source of information, but to obtain further information. An example here may be the basic information sheets, key investor information and other sales documents made available by the provider of the financial instrument.
Trading in financial instruments may be interrupted temporarily, for example due to technical malfunctions or by the execution venue, or may be temporarily unavailable for other reasons. In the case of volatile investments in particular, investors may not be able to sell the investment as a result. In the meantime, losses may occur.
The proprietary custody of securities opens up the risk of loss of the certificates. The replacement of the securities documents embodying the investor's rights can be time-consuming and costly. Self-custodians also risk missing important deadlines and dates, so that certain rights can only be asserted with delay or not at all.
Securities acquired abroad are usually held in custody by a third party domiciled abroad selected by the custodian bank. This can lead to increased costs, longer delivery times and uncertainties with regard to foreign legal systems. In particular, in the event of insolvency proceedings or other enforcement measures against the foreign custodian, access to the securities may be restricted or even excluded.
The acceptance of third-party funds as deposits or other unconditionally repayable funds from the public is referred to as deposit business. Legally, this is usually a loan. As a rule, a distinction is made between cash deposits and fixed-term deposits. Deposits in a cash deposit account are subject to a fixed interest rate without a fixed term. The deposit is available daily. A fixed-term deposit account, on the other hand, has a fixed term during which the investor cannot access the deposit (or can only access it at the loss of the agreed interest).
Inflation risk: Inflation risk is the change in the purchasing power of the final repayment and/or the interest income from an investment. If, during the term of a deposit, inflation changes in such a way that it exceeds the interest rate on the deposit, the investor's effective purchasing power falls (negative real interest).
Default risk: There is a risk that the deposit-taking credit institution may default (e.g. in the event of insolvency), i.e. it may no longer be able to repay the savings deposits. This risk can be mitigated by so-called deposit guarantee schemes, in which the repayment of the savings deposit is guaranteed in part or in full by the deposit guarantee scheme. In Europe, all EU member states have agreed to create national deposit guarantee schemes in accordance with harmonised European requirements. The EEA countries that are not members of the EU (e.g. Norway) have also set up deposit guarantee schemes. These deposit guarantee schemes cover up to a certain amount (in the EU generally up to EUR 100,000) if a bank is unable to repay its clients' deposits.
Interest rate risk: Cash deposits are subject to the risk of a change in the applicable interest rate by the deposit-taking credit institution.
Foreign currency risks: If cash deposits or fixed-term deposits are concluded in a currency other than the investor's home currency, the development of the exchange rate of the foreign currency to the home currency also influences the success of the investment. In addition, there are country risks in the form of influence on capital movements and the transferability of currencies.
Shares are securities issued by companies to raise equity capital and certify an ownership right in the company. A shareholder is therefore not a creditor as with a bond, but a co-owner of the company. The shareholder participates in the economic success and failure of the company through profit distributions, so-called dividends, and the performance of the share price.
The extent of the participation in the company evidenced by the share is determined, in the case of par value shares, by the fixed nominal amount stated. A no-par share is denominated in a specific number of shares. The participation quota of the individual shareholder and thus the scope of their rights is derived from the ratio of the number of shares held by them to the total number of shares issued.
There are different types of shares that carry different rights. The most important types are ordinary shares, preferred shares, bearer shares and registered shares. While ordinary shares do carry voting rights, preferred shares do not. To compensate for this, preferred shareholders receive preferential treatment, e.g. in the distribution of dividends. A bearer share does not require the shareholder to be entered in a share register. Shareholders can exercise their rights even without registration. Bearer shares are therefore more easily transferable, which typically improves their tradability. In the case of a registered share, the name of the holder is entered into the company’s share register. Without registration, the rights arising from ownership of the share cannot be exercised. Registered shares with restricted transferability are shares whose transfer to a new shareholder is also subject to the company's approval. Registered shares with restricted transferability are advantageous for the issuing company in that it retains an overview of the group of shareholders. However, registered shares with restricted transferability do not occur frequently.
Participation in a stock corporation confers various rights on shareholders. Share holder rights are defined by the local stock corporation acts and the articles of association of the company concerned. These are essentially property and management rights.
With regard to property rights, the most important are the entitlement to dividends, subscription rights and entitlement to additional or bonus shares:
Bonds refer to a wide range of interest-bearing securities (also known as fixed-income securities). In addition to "classic" bonds, these also include index-linked bonds, covered bonds and structured bonds. The basic mode of operation is common to all bond types. In contrast to shares, bonds are issued by companies as well as by public institutions and governments (so-called issuers). They do not grant the holder any share rights. By issuing bonds, an issuer raises debt capital. The purchaser of the bond becomes the creditor of a monetary claim against the issuer (debtor). Bonds are usually tradable securities with a nominal amount (amount of debt), an interest rate (coupon) and a fixed term.
As with a loan, the issuer undertakes to pay the investor a corresponding interest rate. Interest payments can be made either at regular intervals during the term or cumulatively at the end of the term. At the end of the term, the investor also receives the nominal amount. The amount of the interest rate to be paid depends on various factors. The most important parameters for the level of the interest rate are usually the creditworthiness of the issuer, the term of the bond, the underlying currency and the general market interest rate level.
Depending on the method of interest payment, bonds can be divided into different groups. If the interest rate is fixed from the issuance over the entire term, we speak of "fixed rate bonds", for example. Bonds for which the interest rate is linked to a variable reference interest rate and whose interest rate can change during the term of the bond are called "floating rate bonds". A possible company-specific premium or discount on the respective reference interest rate is usually based on the issuer's credit risk. A higher interest rate generally means a higher credit risk. Just like shares, bonds can be traded on stock exchanges or over the counter.
The returns that investors can achieve by investing in bonds result from the interest on the nominal amount of the bond and from any difference between the buying and selling price. Empirical studies show that the average return on bonds over a longer time horizon has historically been higher than that on fixed-term deposits, but lower than that on stocks (source: Siegel, J. (1992). The Equity Premium: Stock and Bond Returns Since 1802. Financial Analysts Journal, 48(1), 28-38+46).
Investments in commodity products are counted among the alternative asset classes. Unlike shares and bonds, commodities, if traded for the purpose of investment, are usually not physically delivered but traded via derivatives (mostly futures, forwards or swaps). Derivatives are contracts in which the parties to the contract agree to buy or sell a particular commodity (underlying asset) at a specified price in the future. Depending on whether the market price of the commodity is above or below the agreed price, the value of the derivative is positive or negative. In most cases, there is no actual delivery of the commodity, but a settlement payment for the difference between the market price and the agreed price. This approach facilitates trading as challenges such as storage, transportation and insurance of the commodities can be ignored. However, this synthetic way of investing in commodities comes with some peculiarities that need to be taken into account. Commodities only provide an investor with the prospect of income through price gains and do not offer any distributions.
If the investor wishes to invest in commodities, in addition to a direct investment in the commodity, which is generally not suitable for private investors, they can, for example, also buy shares in a commodity fund or a security that tracks the performance of commodities.
Open-ended commodity funds share the characteristics, operation and risks of the open-ended investment funds described elsewhere. In addition to these risks, there are also risks specific to the investment of commodities. Open-ended commodity funds invest primarily in commodity equities (i.e. companies associated with the mining, processing and sale of commodities) or derivatives of the relevant commodity. Open-ended commodity funds usually have an active fund management that is responsible for the purchases and sales within the fund. Ongoing fees are charged for this, which can be comparatively high. Passive investment instruments, such as ETFs, are usually cheaper as they only track a commodity index (consisting of several different commodities).
If the investor wishes to invest in only one commodity, they must buy a corresponding security that tracks the performance of that commodity (exchange-traded commodities, ETCs). Like ETFs, ETCs are traded on the stock exchange. However, there is an important difference to note: The capital invested in an ETC is not a special asset that is protected in the event of the issuer's insolvency. An ETC is in fact a debt security of the ETC issuer. Compared to an ETF, investors in an ETC are therefore exposed to counterparty risk. To minimise this risk, issuers use different methods of collateralisation. The criteria relevant for the selection of an ETF are correspondingly applicable to ETCs (cf. Section 7.5).
Investments in foreign currencies offer investors an opportunity to diversify their portfolios. Furthermore, investments in the aforementioned asset classes, among others, are often associated with the assumption of foreign currency risks. If, for example, a German investor invests directly or indirectly (e.g. via a fund or ETF) in American equities, their investment is subject not only to equity risks but also to the exchange rate risk between the Euro and the US dollar, which can have a positive or negative impact on the value of their investment.
This asset class includes residential real estate (e.g. apartments and houses), commercial real estate (e.g. office buildings or retail space) and companies that invest in or manage real estate. The investment can be made either directly through the purchase of the properties or indirectly through the purchase of shares in real estate funds, real estate investment trusts (REITs) and other real estate companies.
Open-ended real estate funds share the characteristics, mode of operation and risks of the open-ended investment funds described elsewhere. The main characteristic is that the fund's assets are predominantly invested in real estate (e.g. commercially used land, buildings, own construction projects). Special legal provisions apply to the redemption of unit certificates. Investors must hold open-ended real estate funds for at least 24 months and give 12 months' notice of redemption. Furthermore, the investment conditions of open-ended real estate funds may stipulate that the fund units can only be returned to the capital management company on certain dates (at least once a year). The Terms of Investment may also stipulate that the redemption of units may be suspended for a period of up to three years. In addition to the risks inherent in an investment in real estate, there are therefore special risks associated with restricted redemption or liquidity.
Investment funds are vehicles for collective investment. In the EU they are subject to the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive and the applicable national laws. Foreign investment funds may be organised in the same or similar way to UCITS funds. However, there may also be significant legal or other differences. If foreign investment funds are distributed in the EU, certain legal requirements must be met, compliance with which is checked by the national regulators.
Open-ended investment funds (unlike closed-ended investment funds) are open to an unlimited number of investors. In an open-ended investment fund, a capital management company usually pools the money of many investors in a special fund. However, special forms of investment funds are also possible (such as investment stock corporations or investment limited partnerships). The capital management company invests these funds in various assets (securities, money market instruments, bank deposits, derivative instruments, real estate) in accordance with a defined investment strategy and the principle of risk diversification and manages them professionally. As separate assets, the fund assets must be kept strictly separate from the asset manager’s balance sheet for reasons of investor protection. For this reason, the assets belonging to the investment fund are held in custody by the so-called custodian.
Investors may acquire a co-entitlement to the fund assets at any time by purchasing investment unit certificates via a credit institution or the capital management company. The value of an individual investment unit certificate is calculated by dividing the value of the fund assets by the number of investment unit certificates issued. The value of the fund's assets is usually determined using a predefined valuation procedure. For exchange-traded investment funds, continuous exchange trading is also available for pricing and acquisition.
The investment units can be liquidated in two ways. Firstly, it is generally possible to return the investment unit certificates to the Investment Management Company at the official redemption price. Secondly, the investment unit certificates may be traded on a stock exchange. Third-party costs (e.g. issue premium, redemption discount, commission) may be incurred in the case of both the purchase and the liquidation of investment unit certificates.
The key investor information, the sales prospectus and the investment conditions provide information on the investment strategy, the ongoing costs (management fee, operating costs, costs of the custodian, etc.) and other key information relating to the open-ended investment fund. In addition, the semi-annual and annual reports to be published are an important source of information.
The different types of open-ended investment funds can be differentiated in particular according to the following criteria:
Exchange Traded Funds ("ETFs") are exchange-traded open-ended investment funds that track the performance of an index - such as the global stock index MSCI World. They are also referred to as passive index funds. In contrast to active investment strategies, which aim to outperform a benchmark by selecting individual securities ("stock picking") and determining favourable times for entry and exit ("market timing"), a passive investment strategy does not aim to outperform a benchmark, but to replicate it at the lowest possible cost.
Like other open-ended investment funds, ETFs give investors access to a broad portfolio of stocks, bonds or other asset classes such as commodities or real estate. Unlike other open-ended mutual funds, ETFs are usually not bought or sold directly from a capital management company; instead, trading takes place on an exchange or other trading venue. Thus, an ETF can be traded on securities exchanges just like a stock. To improve liquidity, market makers are usually appointed for ETFs to ensure sufficient liquidity by regularly providing bid and ask prices. However, there is no obligation to provide liquidity.
ETFs can replicate their underlying indices in two different ways. In the case of physical replication, the index is replicated by purchasing all index components (e.g. all the shares of the MSCI World Index) or, if applicable, a relevant subset. In the case of synthetic replication, the ETF provider concludes an agreement in the form of a swap with a bank (or several banks) in which the exact performance of the desired index is guaranteed and collateralised. Thus, a synthetic ETF generally does not hold the underlying securities.
ETFs are a special type of open-ended investment fund. They are therefore subject to the same risks as other types of open-ended investment funds (see above). In addition, there are ETF-specific risks:
When selecting ETFs, the following criteria in particular should be taken into account:
In addition, so-called "ESG criteria" can also be taken into account when selecting ETFs. These are factors that characterise particular environmental, social and governance (ESG) risks. ESG criteria are used to assess the extent to which companies align their organisation and business activities with these factors. Certain indices and corresponding ETFs only track companies that operate in accordance with ESG criteria. Thus, the consideration of these criteria when selecting ETFs can also be suitable in order to mitigate certain risks and, where applicable, to lend weight to idealistic objectives in the investment of capital. However, the criteria explained above should always be taken into account when selecting an ESG-compliant ETF.
Cryptocurrencies, also known as virtual currencies, are defined as a digital representation of value that is not created or guaranteed by a central bank or government agency and does not need to be linked to legal tender. Similar to central bank currencies, cryptocurrencies are used as a medium of exchange and can be transferred, held or traded electronically. Examples of well-known cryptocurrencies are Bitcoin (BTC), Ether (ETH), Ripple (XRP) and Litecoin (LTC).
As exchangeable (fungible) units of value, so-called tokens, cryptocurrencies or other assets are digitally generated in a publicly visible database ("distributed ledger") distributed over a large number of network participants. The creation of new tokens is usually done through a computationally intensive, cryptographically sophisticated process ("proof of work") known as "mining". New information, such as transaction data, is communicated by so-called "nodes" within the peer-to-peer network, validated, and added to the database in blocks by "miners" in a nearly irreversible manner. Because this process resembles a chain, this decentralized database is also known as a "blockchain." The blockchain records the entire history of the database. A copy of the transaction history is stored with all network participants. Consensus between network participants about the state of the blockchain is established through adherence to rules defined in the decentralized network’s protocol.
In addition to direct investment in cryptocurrencies via the corresponding crypto platforms or exchanges, it is also possible to invest via exchange-traded products (ETPs), which track the value of an underlying, e.g. cryptocurrencies. The buyer of an ETP is (usually) entitled to payment of a certain amount of money or to delivery of the underlying against the issuer of the ETP. The terms and conditions of such a claim are usually explained in the issuer's product documentation. If the issuer becomes insolvent and/or any possible collateralisation of the product is not of value or the delivery of the underlying is partially or completely impossible, the investor may thus suffer a substantial or even total loss.
Certificates, leveraged products, warrants and other complex financial instruments ("derivatives") legally are debt securities. They can securitise the investor's claim against the issuer for the repayment of a cash amount or for the delivery of financial instruments or other assets and, if applicable, also for payments during the term. The performance of a derivative depends on the performance of one or more underlyings. Underlyings can be, for example, individual shares, baskets of shares, currencies, commodities or indices.
Derivatives may have fixed terms, e.g. over several years, or may be issued without a fixed term, also known as "open ended". Depending on the structure, both the issuer may have a termination right that leads to early redemption and the investor may have a so-called exercise or redemption rights during the term or at defined times. Details of this are explained in more detail in the product terms and conditions of the respective derivative.
The performance of a derivative depends on the performance of the respective underlying and the structure of the respective product. Depending on the structure, factors such as dividend payments, interest rates, exchange rates or volatility may affect the value of the derivative.
To calculate the unit price of a derivative, the issuer uses the theoretical fair value based on financial mathematical models. Any difference between the calculated theoretical value and the actual unit price may result, for example, from the Issuer's margin, any distribution fees and the costs of structuring, pricing, settling and hedging the product. Accordingly, the buying and selling prices (bid and ask prices) set by the Issuer during the term are not directly based on supply and demand for the respective product, but rather on the Issuer's pricing models.
When issuers set prices, costs do not have to be spread evenly over the term, but can be deducted at the beginning of the term. The types of costs include, for example, management fees charged or margins included in the products.
In principle, derivatives can be divided into the categories of leveraged products and investment products.
Leveraged products can participate more strongly in the performance of the underlying via so-called leverage - this also means that the associated risks (in particular price risk and risks due to leverage and knock-out) increase. Some types of leveraged products have a so-called knock-out threshold, which means that the product in question expires worthless if the threshold is touched. This means that the investor can no longer participate in the subsequent performance of the underlying.
Warrants represent the right to purchase (call option, also known as a "call") or sell (put option, also known as a "put") the underlying at a predetermined strike price within a subscription period (American option) or at the end of a subscription period (European option) in accordance with a specified subscription ratio.
Instead of the actual purchase or sale, resulting in the delivery of the underlying, the product terms and conditions of warrants generally provide for the payment of a settlement amount. In the event of a payment, no purchase (and conversely no sale) of the underlying takes place upon exercise of the option; rather, the difference between the agreed strike price and the current market value of the underlying is calculated and paid out to the investor.
The unit price of a warrant is influenced by the performance of the underlying, the (remaining) term and volatility, among other factors. Thus, although the price is directly related to the underlying, it is usually well below it. This means that the buyer of the warrant can participate in price changes of the underlying to a greater extent in percentage terms than in the case of a direct investment in the underlying. This effect is also known as "leverage". Accordingly, price risks are greater and can lead to a total loss of the investment.
With knock-out products, the investor also participates disproportionately in price movements of the underlying. This means that price losses of the underlying security have a correspondingly greater impact on the investor's investment than would be the case with a direct investment in the underlying security. The product therefore carries a greater risk, up to and including total loss. Similar to warrants, knock-out products also offer the opportunity to profit from rising prices of the underlying (long or bull products) or falling prices (short or bear products).
A relevant difference to warrants is the so-called knock-out threshold. If this threshold is touched, the instrument becomes worthless and the investor suffers a total loss.
Factor certificates offer another opportunity to participate disproportionately in the performance of the underlying. The performance of a factor certificate is determined by the intraday change in the value of the underlying multiplied by the respective factor. The fact that the performance of the certificate is always calculated against the respective closing price of the underlying on the previous day results in a path dependency. This entails considerable risks and losses may also be incurred on the factor certificate during sideways phases of the underlying.
Investment products can be divided into products that participate directly in the performance of the underlying and those with a predefined redemption profile.
Discount certificates, for example, belong to the latter category. These can be purchased at a price below the current price of the underlying asset. This price reduction - also known as a "discount" - acts as a risk buffer and may still allow positive returns even if the price of the underlying asset moves sideways. In return, the investor forgoes participation in a strong price increase, as the potential return is limited by an upper threshold, the so-called "cap".
Express certificates also follow a predefined payout profile. The performance of the underlying is monitored at certain points in time. If the underlying is quoted above the starting price, the investor receives a payout equal to the nominal value of the certificate plus a defined express amount. If the underlying is below the starting price, this analysis is repeated at the next observation date. In the event of price losses, a safety buffer may be provided to protect the investor against price setbacks up to a predetermined level. However, if the prices of the underlying fall beyond this, the investor is exposed to the same risk as with a direct investment in the underlying.
As a classic participation certificate, index certificates are based on a stock, security, commodity or other type of index. They track the performance of the underlying index on a one-to-one basis. They are therefore particularly suitable for investors who wish to implement the investment strategy of a specific index. An alternative to index certificates are index funds, which also track an index. Index certificates usually incur lower costs than index funds, but are associated with additional risks.
If the certificate is based on a stock index, it is important to determine whether the certificate relates to a performance index or a price index. In the case of a performance index, dividend payments are included, whereas in the case of a price index they are not. In the case of indices that are not quoted in the investor’s home currency, there is also a currency risk. However, this can be excluded with so-called quanto index certificates.
Basket certificates represent a basket of shares or other investment products and are a variation of index certificates. The certificates differ in terms of the distribution of dividends, the mechanism for maintaining the basket composition and the management fee charged for this.
Another form of complex financial instruments are so-called complex ETFs. In analogy to the derivatives described above, complex ETFs may, depending on their structure, also achieve a leverage effect (e.g. leveraged ETFs) and/or an opposite participation in the performance of the underlying (e.g. short ETFs). In addition to the risks of all other complex financial instruments, as well as the special risks of synthetically replicating ETFs already mentioned, complex ETFs may also entail the special risk arising from the daily resetting of the leverage or short factor. The fact that the performance is calculated daily against the respective underlying closing price of the respective previous day results in a path dependency. Even if the underlying moved sideways over several days, the ETF may suffer losses.
Buy and sell orders shall be executed by the custodian bank in accordance with its special conditions for securities transactions and its execution policy. If the orders are placed by an asset manager, its selection or execution principles must also be observed. In addition, the respective Conflict of Interest Policies may contain relevant provisions. If necessary, the client's orders can be combined with orders from other clients when they are executed by a third party. Such so-called aggregated orders enable cost-effective trading in securities and are therefore in principle also advantageous for the client, since without them it would be impossible to provide a cost-effective service for a large number of clients. However, in individual cases, aggregated orders can also be disadvantageous for the individual client. They may, for example, have a negative impact on market pricing or lead to a reduced allocation for the individual client due to an excessively large order volume.
Dispositions of securities made for the investor by a third party can, amongst others, be carried out by means of fixed-price or commission transactions. In a fixed-price transaction, the third party (e.g. the bank) sells or buys the relevant securities directly to or from the client at an agreed price. In a commission transaction, the third party buys or sells the relevant securities for the account of the client, so that the conditions agreed with the counterparty (i.e. the buyer or seller) are economically attributed to the client.
Securities trading may be carried out on securities exchanges or over-the-counter trading venues, such as interbank trading or multilateral trading facilities:
Securities exchanges are centralised and organised markets for trading securities and other financial instruments that are regulated and supervised by state-recognised bodies. These exchanges bring together the supply and demand of a large number of market participants. Trading takes place regularly on securities exchanges; securities admitted to trading on the exchange are traded accordingly. Trading and price fixing are regulated. The various types of stock exchanges can be differentiated according to, among other things, the density of regulation (regulated market or over-the-counter market) and the type of trading (floor trading or electronic trading system). In Germany, securities trading on the stock exchange takes place at various stock exchanges. Trading is mostly carried out via electronic trading systems. Compliance with the previously defined rules is monitored by the stock exchange supervisory authority.
Off-exchange trading, which is also referred to as direct trading or OTC trading ("over the counter"), refers to any trading that takes place outside an exchange. In this case, the investor can trade directly with the issuer or a market maker, for example.
In floor trading, the so-called lead broker determines the corresponding price either within the framework of variable trading or according to a single price. When determining the unit price, the most-execution principle applies. This means that the price at which the largest turnover occurs with the smallest overhang is determined as the execution price. In electronic trading, the price is determined by electronic systems according to certain rules and usually also in compliance with the most-execution-principle. In order to increase the tradability of less liquid securities and thus the possibility of concluding transactions, exchanges enable issuers or third parties commissioned by them to provide additional liquidity. To this end, exchanges conclude contracts with banks, brokerage firms or securities trading houses. As so-called market makers, they undertake to submit buy and sell offers (quotes) for the securities they manage on an ongoing basis. A quote is a bid and ask price for a security. The lower bid price indicates the price at which the investor can sell the security; the higher ask price corresponds to the price at which the investor can buy the security.
Buy and sell orders are executed by the custodian bank in accordance with its special conditions for securities transactions and its execution policy. However, instructions from the client take precedence. These instructions may specify price and time limits (limits, validity period or limit supplements). In this way, the client can "fine-tune" the respective order. In the following, particularly relevant examples of instructions will be explained:
Various investment services are offered. Before investors decide on an offer, it is very important to understand the differences and associated typical risks and conflicts of interest.
In the case of execution-only transactions, the custodian bank merely acts at the instigation of the client in the execution of orders. No advice or assessment of appropriateness or suitability takes place. Due to legal regulations, execution-only transactions may solely be carried out for non-complex financial instruments (e.g. shares, money market instruments, bonds, or mutual funds). The client receives a confirmation of the order execution, which contains all relevant transaction details.
A non-advisory transaction is one in which the client makes an investment decision without having previously been given an investment recommendation by a bank. The bank's duty of exploration is considerably reduced compared to investment advice or wealth management. In contrast to execution-only transactions, however, there is at least a limited duty of exploration as well as a duty to conduct an assessment of appropriateness.
In the case of contract brokerage, no advice is given to the client. The client is merely provided with the possibility to buy or sell a financial instrument. An assessment of the suitability of the financial instrument for the client is not required and therefore does not take place, or only to a limited extent. Advertisement of a specific financial instrument or of a group of instruments during the brokerage process may give the client the false impression that the service is investment advice.
Investment brokerage involves the acceptance and transmission of client orders relating to buying or selling financial instruments. Investment brokerage is usually concluded on the basis of verbal explanations of the investment concept, possibly with the handing over of prospectuses or other sales documents. The investment intermediary has no express power of attorney from the client and is only a messenger.
Contract brokerage, on the other hand, means buying or selling financial instruments in the name of a third party for the account of a third party. In this case, the client orders are processed via a third party (contract broker). Contract brokers therefore act as representatives with corresponding power of attorney for their clients. The contract is concluded directly between the client and the buyer or seller of the financial instruments.
Providing investment advice means the provision of personal recommendations to a client to buy or sell financial instruments, either upon client request or at the initiative of the investment advisor. The advisor is obliged to assess the suitability of the recommended investment for the client, taking into account the client's investment objectives, financial situation, risk appetite and knowledge and experience. However, the decision to implement the advisor's recommendation must be made by the client.
There are basically two remuneration models: fee-based and commission-based advice. The remuneration of both types of investment advice harbours a potential for conflict. In the case of fee-based advice, the client is usually invoiced directly for the advisory service on a time basis. This gives the advisor the incentive to bill for as many advisory hours as possible. In the case of commission-based advice, the service is not charged directly to the client because the advisor receives a sales commission from their employer or from the manufacturer of the financial instrument (e.g. from a fund manager or the issuer of a structured product). This entails the risk that the client is not offered the most suitable security for them, but the one that is most lucrative for the advisor.
Wealth management (also known as financial portfolio or asset management) differs from the investment services described above. While wealth management differs from intermediary services in that the interest of the investor (as opposed to the interest of the person seeking capital) is decisive, it can be distinguished from advisory services both on the basis of the disposition authority granted for the investor's assets and on the basis of the nature of the contract, which is intended to be of a (certain) duration. Wealth management has in common with investment advice that both the wealth manager as well as the investment advisor have to examine the suitability of the investment for the client, taking into account the client's investment objectives, financial situation, risk appetite and knowledge and experience.
The wealth manager receives from the client the authority to make investment decisions at their own discretion if they appear to them to be prudent for the management of the client's assets. In making investment decisions, the wealth manager does not have to seek instructions from the client, but they are bound by the previously agreed investment guidelines which regulate their powers as well as the nature and scope of the service.
Wealth management is typically a service aimed at long-term asset accumulation or preservation. The client should therefore have a long-term investment horizon, as this increases the likelihood that the portfolio can recover in the event of negative performance. It is advisable to submit only such funds into wealth management that are not needed to cover short- and medium-term living expenses or to meet other liabilities.
Wealth management also involves a number of risks for the client's financial situation. Although the wealth manager is obliged to always act in the best interest of the client, wrong decisions and even misconduct may occur. Even in the absence of intent or negligence, general market developments can lead to deviations from the agreed investment guidelines. The general risks of the investment as well as the special risks of the related asset classes also do apply in the case of wealth management.