Deconstructing structured products

Structured products are intricate financial instruments. They are curated by investment banks to offer investors the potential to access specific risk-return traits that are typically not accessible through standard, individual financial assets. 

Ultimately, these are derivative-based products, meaning options, futures, swaps and other complex instruments are pieced together to imitate the returns of a bespoke investment strategy.

It's important to tread carefully when incorporating structured products into your strategy. Simplifying complex investments sounds intuitive, but is it always a good idea to obfuscate complexity? 

Types of structured products

Structured products are a broad concept in which products vary in complexity. However, these can be broadly categorised into Principal Protected Notes (PPNs) and Non-Principal Protected Notes (NPPNs).

PPNs are often hailed as the 'safer' option as they guarantee the return of the initial investment at maturity - this cushions the investor against potential losses. They do this by using zero-coupon bonds for the return of the principal to secure some or all of the principal (and an option with a payoff that is linked to an underlying asset, index, or benchmark)

But, non-protected products, which do not protect your principal through bonds, often have the allure of higher returns due to focusing more on the derivatives. 

How structured products work

The mechanism underlying structured products can be linked to a contractual agreement between the investor and the issuer, often an investment bank. Here, the bank pledges a return linked to the performance of one or more underlying assets or benchmarks, such as equities, indices, commodities, or foreign exchange rates.

As touched on before, some structured products will use various types of bonds in combination with derivatives to achieve specific investment goals. 

This promise of an attractive return can be persuasive for potential investors, but the devil is in the detail of the T&Cs; seemingly minute caveats or clauses might reveal less desirable conditions or risks.

The appeal of structured products

Diversification Benefits

One of the main attractions of structured products is the promise of diversification benefits. These products offer exposure to a variety of different asset classes, sectors, and geographical regions.

Their asymmetric payoff profiles also lead to lower correlations with traditional assets. Consequently, during periods of market stagnation or decline, structured products have the potential to diminish downside risks and enhance the overall risk/return ratio of portfolios.

Customisation

Another appealing aspect of structured products is their customizability. These financial instruments can, in theory, be tailored to fit specific risk-return profiles, such as tuning their exposure to interest rate and credit risk.

Potential Higher Returns

Structured products can offer higher potential returns when compared to more traditional forms of investment. This can be particularly appealing in a high-inflation environment, where many people want higher returns.

Risks and drawbacks of structured products

Complexity and Lack of Transparency

One of the primary criticisms directed at structured products is their complexity. Their architecture, involving a myriad of derivative combinations, can make these products difficult to understand. This complexity often leads to a lack of transparency, making it challenging for investors to accurately gauge the risk-return profile of the product. 

Credit Risk

A substantial risk associated with structured products is credit risk – the risk that the issuer might default or become insolvent. In such an event, investors stand to lose part or all of their initial investment. This is a risk that should not be underestimated as we only have to go back as far as 2008 for widespread examples of it happening.

Market Risk

Given their inherent connection to the performance of underlying assets, structured products are exposed to market risk. Adverse movements in the value of these assets can have a detrimental impact on your returns, and sometimes capital protection is only offered up to a certain threshold. 

Liquidity Risk

Structured products are often less liquid than more traditional financial assets such as bonds or equities. This lack of liquidity means that if an investor needs to exit their position before the product's maturity, they may have to sell at a discount. This liquidity risk can result in lower expected returns.

Costs and Fees

Structured products typically come with higher costs and fees than other more straightforward investment products. These costs are often hidden within the product's structure and can significantly diminish the potential returns, particularly when considering risk-adjusted returns. This also adds to the lack of transparency, this time in the form of higher-than-expected costs.

Demystifying structured products: reality vs. promise

The allure of structured products often stems from their initial promise: the potential for higher returns, capital protection, and the opportunity to simplify an otherwise complex and diverse set of investments. But, reality can sometimes be very different. 

For instance, returns linked to an equity index through an options contract may not fully capture market gains due to predefined caps. Similarly, in declining markets, promised capital protection can fall away if declines exceed certain thresholds, leading to substantial losses. 

To make things even more complex, some structured products calculate returns based on specific points in time or the average performance over a period, meaning it may misrepresent performance. 

So, while structured products promise to offer an investment solution tailored to the investor's risk and return preferences, they often fall short of their promise of simplifying otherwise complex investments whilst limiting losses and yielding high returns.

Final words

Structured products certainly have their benefits. They offer good diversification and customisation whilst benefiting, sometimes, from higher returns than many traditional investments. However, they also pose a lot of risks, some of which is obscured in nature or simply misunderstood.

For those considering delving into the world of structured products, it is vital to fully understand every detail of the product you’re investing in. For help in discussing complex investments, or when searching for high returns whilst maintaining a sensible level of risk, feel free to reach out to us to discuss an investment plan that helps meets your goals.