Introduction:
Structured products are a diverse category of financial instruments that combine a traditional security with one or more asset classes into a single structure. This structure, often referred to as a “basket,” determines the investment’s characteristics, including potential returns, downside protection, tax implications, time horizon, and associated risks. While structured products offer unique investment opportunities, they also introduce complexity and potential risks that investors need to understand.
Structured products can be thought of as financial instruments issued by banks with varying terms, payouts, and risk profiles. These products are designed to track the performance of an underlying asset, which can be an equity, index, commodity, currency, or a combination of these. Unlike standardized financial products, each structured product is tailored to meet specific investment goals and is determined at the time of issuance by the issuing bank.
Diverse Exposure to Multiple Markets
Structured products offer exposure to a wide range of markets and underlying assets. Investors can access:
- Shares of major companies like Anglo American, Barclays, BHP Billiton, Marks & Spencer, and Tesco.
- Indices such as FTSE, Dow Jones, S&P, and Nikkei.
- Baskets of stocks, providing access to groups of equities based on specific market sectors.
- Interest rates and inflation using benchmarks like CPI, RPI, and LIBOR.
- Commodities, including precious metals like platinum, gold, silver, as well as agricultural commodities and oil.
- Exchange rates for various currencies.
Structured products cater to specific needs that may not be achievable through simpler financial products available in the market. Therefore, they are often used to enhance diversified portfolios, offering a customizable risk/reward profile.
Characteristics of Structured Products
Structured products share several common characteristics:
- Fixed Term: Like traditional bonds and options, structured products have fixed maturities or expiration dates. This means they are redeemed at a specified date in the future. The shortest term available is typically three months, with an average maturity in the United States of around three years.
- Capital Protection: Structured products can provide full or partial capital protection. Full capital protection ensures that investors receive at least their original investment at maturity, while partial protection guarantees a reduced percentage of the original investment. It’s essential to understand that this protection is only available at maturity, so investors should be prepared to hold the investment until then.
- Formula-Based Returns: Structured products are based on specific formulas tailored to market outlooks or individual investor views. These formulas consider factors such as the initial and final valuation of underlying assets, participation rates (percentage change in the underlying asset), and the investment’s term. Probability tables of potential returns are often included in prospectuses to demonstrate hypothetical probabilities, with actual returns depending on the end value of the investment.
- The Role of Derivatives: Structured products frequently incorporate derivatives to make informed bets on future market performance. Derivatives are financial contracts whose values depend on underlying assets such as indices, commodities, currencies, stocks, or bonds. This allows structured product manufacturers to customize returns based on their market expectations.
Asset Classes and Complexity
Structured products can be linked to a wide variety of underlying asset classes, ranging from bonds, equities, commodities, and currencies to managed funds, real estate investment trusts (REITs), and more. The complexity of structured products can vary, from principal-protected notes tied to familiar equity indices to more intricate products linked to asset-backed securities, index-linked notes, and derivatives.
Constructing a Structured Product
The construction of a structured product typically involves combining a zero-coupon note, certificate of deposit (CD), or warrant with another asset or derivative whose value is realized at the note’s maturity. For example, a structured note may be linked to an index fund, with the investor’s principal returned at maturity, along with any increase in the fund’s underlying value.
Conclusion:
Investors must exercise caution when considering structured products due to their complexity, varying risk profiles, and the potential illiquidity until maturity. These unique investments can play a valuable role in diversifying portfolios and addressing specific investment objectives when understood and used effectively.