In recent years, structured products have gained favour among retail investors. Investment banks promote these investments as sophisticated tools to help investors manage downside risk, enhance returns, or achieve other investment objectives.
Particularly within the high street banking sector, sales have grown briskly since 2006 and, despite a decline after the 2008 market crisis, some industry sources expect a further rebound in sales and a flurry of new products in the future. With this in mind, it may be useful to understand how the products work and to evaluate the costs, benefits, and tradeoffs before considering investing.
A structured product is an investment that promises to pay a future amount based on the performance of an underlying asset, such as a stock, market index, or commodity.
The investment return is typically linked to a preset formula. Most structured products are designed to either preserve capital or enhance returns. They offer a specific payout over a designated period or at maturity, and the final payout depends on the performance of the underlying asset and the ‘derivatives’ that back up the investment.
A derivative is a financial instrument that allows an investor to benefit from the returns from a specified asset without actually owning the asset itself.
Since the product and the derivatives are typically issued by an investment bank, the investor is exposed to the risk of that entity failing, e.g. Lehman Brothers during the recent financial crisis.
One commonly sold product offers a minimum return equal to the original investment plus a potential return tied to performance of an underlying asset; e.g. as a stock market index. If the index drops during the term, the investor gets his money back but, if the index rises, he would receive some growth. It is important to stress that, due to the cost of the capital guarantee, only a portion of the underlying assets’ gains would be received.
The following summarizes a few common characteristics of structured products:
Most products have a complex design which can make analysis of cost, 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.
These products tend to carry significant costs that in some cases are difficult to quantify, especially if an investor lacks the technical knowledge to analyse the underlying components of the investment.
In return for receiving a prescribed payout, investors must accept a trade-off 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 trade off. 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. This is what happens within a structured product.
First, there are the inherent risks of the underlying investment (e.g., the stock or index). Investors also are exposed to the risk of the issuing firm failing to honour it’s liabilities. The contract is an agreement with the issuer to make a pre-determined payment in the future and is therefore 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.
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. However, this benefit generally comes at the expense of lower potential for growth.
Please avoid structured products!
In many cases, the strategy can be replicated at a lower cost, and potentially with less risk. Many investors would prefer an alternative that is less complex and more transparent.
Our view is that structured products are designed by and for the benefit of the product providers rather than for the client. Their purpose is to attract capital and to sell the dream of good returns with no risk to your capital. There is no such thing as a ‘free lunch’ and you pay a heavy price for a guarantee that may not even turn out to be guaranteed!
Should you come across a structured product that looks attractive at first glance, we would be happy to check through the terms and conditions and provide you with impartial advice regarding the various risks and benefits.
We believe that with careful financial planning and by investing in a low cost, diversified portfolio you can avoid the need to invest in opaque, expensive structured products and can achieve the returns that you require in order to meet your long term objectives.