Navigating Structured Products

Navigating Structured Products

In recent years, structured products have gained favor among retail investors in Europe and the US. Investment banks promote these securities as sophisticated tools to help investors manage downside risk, enhance returns, or achieve other investment objectives.

Sales have grown briskly since 2006, and despite a decline after the 2008 market crisis, some industry sources expect a rebound in sales and a flurry of new products in the future.1 With this in mind, it may be useful to understand how the products work and to evaluate the costs, benefits, and tradeoffs before considering one in your investment strategy.

 

Basic design

A structured product is a contract that promises to pay a future amount based on the performance of an underlying asset, such as a stock, market index, or commodity. The payoff is typically linked to a preset formula. Most structured products are designed to either preserve capital or enhance returns, and are typically issued as notes.2 The notes offer a specific payout over a designated period or at maturity, and the final payout depends on the performance of the underlying asset as well as the value of the derivatives written on it. Since the product typically is issued by an investment bank, the investor is exposed to the credit risk of that entity.

One common product, a principal-protected note, generally offers a minimum return equal to the original investment, plus a potential return tied to performance of an underlying asset, such as a stock market index. If the index drops during the term, the investor gets his money back, but if the index rises, he may receive the upside gain, but usually only a part of the underlying asset’s gain. Structured products can be replicated by portfolios composed of an interest-bearing instrument, such as a certificate of deposit or zero-coupon bond, equity securities, and options or other derivative securities whose performance is linked to the underlying index.3

The following summarizes a few common characteristics of structured products:

  • Complex design: Most products have a complex design, which can make analysis of pricing, risk exposure, and potential outcomes more difficult. Some investors equate this complexity with higher potential returns, when, in fact, it may only mask high fees and risk. Worse yet, investors may not understand the range of possible outcomes. During the 2008 market crisis, some investors learned a hard lesson when the issuing firm went bankrupt or when their structured product experienced losses from poor performance of the underlying asset.
  • Substantial cost: These products tend to carry a significant markup and costs that in some cases are difficult to quantify, especially if an investor lacks the technical knowledge to analyze the underlying components of the strategy.
  • Replication: The payoff of virtually any structured product can be replicated in a portfolio by holding the underlying securities, then buying or selling derivatives written on those securities. In many cases, the costs associated with the replication portfolio are much lower than the structured product itself.
  • Tradeoffs: In return for receiving a prescribed payout, investors must accept a tradeoff in the form of a lower return and/or limited upside potential. When evaluating a structured payout, remember that there is no free lunch in the risk-return tradeoff. To pursue higher expected returns, you must accept more risk. If you do not want to bear the risk, you must transfer it to other investors and pay them for taking it.
  • Multiple Risks: First, there are the inherent risks of the underlying security (e.g., the stock or index). Investors also are exposed to credit risk of the issuing firm. The contract is an agreement with the issuer to make a pre-determined payment in the future, and thus, it is contingent on the firm being able to deliver. Liquidity risk is another issue. Although many structured products are listed and traded on exchanges, they may be difficult to sell, especially in a volatile market. To avoid a potential liquidity problem, investors should consider the time horizon of the product and attempt to match its maturity to their anticipated financial need or objective.
  • Tax considerations: It is also important to check tax consequences. Some instruments may have certain appeal under the current tax rule. But, often, tax consequences differ according to the investment situation (e.g., whether one buys at the issuance or in the secondary market).

 

Who might benefit?

A structured product might help an investor who needs a specific payout at a designated point in the future and who is willing to pay another party to shoulder much of the uncertainty. But this benefit generally comes at the expense of lower yield or limited upside potential.

One example may be an individual who currently holds restricted company stock whose value may account for a significant portion of his total wealth. Although he might prefer to diversify this exposure, company rules may prohibit a sale until some future date. A structured product might provide protection against the downside risk of the company’s stock (even though this might mean giving up the upside potential of the stock), and at the same time, provide better-diversified exposure to an equity index, such as the S&P 500.

Perhaps most important, investors who are considering a structured product should consider why they even need a highly structured payoff in the future—and if so, whether the payoff can be structured by other means in the portfolio. In many cases, the strategy can be replicated at a lower cost, and perhaps with less risk. Many investors would prefer an alternative that is less complex and more transparent. And as the recent credit crisis taught many investors, it is wise to avoid investing in things you do not understand.

 

Endnotes

1 Larry Light, “Twice Shy on Structured Products?” Wall Street Journal, May 28, 2009.

2 A reverse convertible bond is one example of a yield enhancement tool. It pays investors a higher coupon rate than other comparable bonds due to its higher risk. This risk comes in the form of the issuer having the option to pay off the debt with either cash or a predetermined number of common stock shares. The method of payment at time of maturity will depend on the stock price, and the issuer will pay with common stock when it is advantageous to do so. The reverse convertible bond was popular until the last market crisis, when many investors experienced heavy losses when they were paid off with lower-value stock shares.

3 A call option provides the holder the right to buy the underlying security at a given price at a certain time in the future. A put option provides the holder with rights to sell the underlying security at a pre-specified price on maturity date. (American-style options can be exercised before the maturity date, whereas European-style options can be exercised only on the maturity date.) An option holder will exercise the put or call option only if the payoff is positive.

 

The information, data, analyses and opinions contained herein (1) do not constitute investment advice offered by Socius Family Office, (2) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (3) are not warranted to be correct, complete or accurate.  Except as otherwise required by law, Socius Family Office shall not be responsible for any trading decisions, damages or losses resulting from, or related to, this information, data, analyses or opinions or their use.

Socius Family Office LLC is an investment advisor registered with the Securities and Exchange Commission.