Originated in Europe, structured products have gained popularity in the United States, where they are traded as SEC-registered products. It means that retail investors have access to them in the same way as to bonds, stocks and exchange-traded-funds (ETFs).
Offering customised exposure to various hard-to-reach asset classes, structured products have proved themselves as an effective supplement to traditional well-diversified portfolios.
What are structured products?
Also known as market-linked investments, structured products represent pre-packaged structured financial instruments, which are based on the performance of a single security, a basket of securities, indices, commodities, options, debt issuance or foreign currencies. Structured products are issued by banks and have various terms, payouts and risk profiles.
Like other popular market instrument, many structured products are hybrid securities. Typically, they consist of two parts – a note and a derivative. The note may bring you an interest at a particular specified rate and interval. The derivative part determines payment at maturity, which gives the issuer the right to sell you or buy from you the referenced security at a specified price.
the US Securities and Exchange Commission (SEC) defines structured products as "securities whose cash flow characteristics depend upon one or more indices or that have embedded forwards or options or securities where an investor's investment return and the issuer's payment obligations are contingent on, or highly sensitive to changes in the value of underlying assets, indices, interest rates or cash flows".
Most structured products presuppose fixed maturity and may pay you an interest rate or coupon rate. They are usually created to meet the special needs that can’t be met through the use of standard financial instruments, available on the market.
Structured products examples
You wonder how do structured products work? Consider that a famous and trustworthy bank issues a structured product in the form of notes with a face value of $1,000. Each note represents a package, which consists of the two components – a zero-coupon bond and a call option on the underlying asset (a common stock or an ETF, following the popular market index). The maturity of this note is 3 years.
The underlying principle of this instrument is pretty simple. On the issue date you pay the face amount of $1,000. This note is fully-protected and you will get your money back at maturity, no matter what happens to the underlying asset.
Speaking about the performance component, the underlying asset is priced as a European call option and will have intrinsic value at maturity, if its value at this date will be higher than its value at the issue date. If applicable, you will earn that return, if not – you’ll get nothing in excess of your $1,000.
Although, a full principal protection offers a key benefit of investing in structured products, an investor may trade off some a part or all the protection in favour of more attractive performance protection.
Types of structured products
Structured products are not homogeneous and may be subdivided into several types. First, they may be principal-protected and non-principal protected. Further, they can be classified by different derivatives and underlying assets.
Principal protected structured products offer return of principal at maturity. They are suitable for traders and investors, who want to profit from a certain view of the market, but at the same time want to protect the principal value of their investment. Usually, they are 100% protected, but they can be also protected partially. The returns on this type of products are usually payable at maturity and depend on the performance of the underlying assets – commodities, indices, or equities.
Non-principal-protected structured products won’t return the principal at maturity. In return for exposing their principal at risk, traders may be offered higher current yields than could be gained by investing directly in an equity security.
Besides, the structured products can be classified according to the underlying asset, including: interest rate-linked notes and deposits, FX and commodity-linked notes and deposits, equity linked notes and deposits, credit-linked notes and deposits, market-linked notes and deposits, etc.
Features and benefits of structured products
For those who investigate the option to include structured products into their investment portfolio, here are some major characteristics and benefits:
Potential for increased risk-adjusted returns. Structured products may work as an effective supplement to a well-diversified portfolio by accumulating features of several asset classes in one single investment. For example, if we take an index-linked note, it will perform like an underlying index if it increases its value, otherwise, if it’s value decreases, it will act more like a debt security. Structured products may decrease the overall portfolio’s volatility, offering the opportunity to enhance returns.
Customisation of risk/return profile. Structured products provide the possibility to tailor the risk/return profile of the underlying investments to either maximise expected performance or hedge risks related to individual securities — commodities, currencies and other investments. Many enhanced growth and enhanced yield structured products are developed to outperform the underlying asset, while many principal-protected products are made to hedge against the risk of loss.
Access to previously unattainable investments. Many structured products provide individual investors with an access to various markets that were not readily available through traditional investments due to their high cost or overall complexity. Structured products are considered cost-efficient instruments.
Limited maximum potential loss. One of the most attractive features of structured products is that the maximum potential loss is limited to the initial invested amount. Structured products do not presuppose margin.
Risks of structured products
To take the decision of whether to include structured products or not into your investment portfolio, you should not only consider their key benefits, but also weigh up risks. Some of the most significant risks of structured products include the following:
Potential principal loss. Some structured products are principal-protected at maturity. It means that an investor may return the full principal amount only if he holds the structured product to maturity date. However, structured products are considered medium-term investments (1-10 years) and during this period the price may fluctuate considerably. If the investor sells this product before the maturity, the price may be lower than the initially invested amount.
Market price fluctuations. The value of structured products depend on numerous factors, which may be pretty unpredictable, including: the underlying asset's price, dividend rates, interest rates, time to maturity and geopolitical environment.
Credit risk. Some structured products are issued in the form of unsecured debt. It makes them dependent on the issuer's credit risk and default risk.
High complexity. It is not very easy to calculate the returns from structured products. It means it is more difficult to estimate and predict the performance of the structured products than that simply own the underlying asset.
Lack of liquidity. Structured product may be traded on stock market exchanges as well as over the counter. Even if traded on a traditional exchange, there is no guarantee of a liquid trading market for a particular structured product.
Investing in structured products
Structured products trading can be performed either on the traditional stock exchanges or over-the counter. Traded as ordinary shares on the regulated exchanges, structured products provide investors with a high level of regulatory oversight and market supervision.
Issues of structured products must comply with all the listing authority's requirements and provide all the necessary documents containing full details about their products. There is a huge variety of structured products available on stock exchanges. You should carefully consider whether they are suitable for your portfolio and meet all your investment requirements before trading.