In the past two decades, structured products have opened a vast universe of possibilities for investors. Once, most private investors were limited to straightforward equity and bond investments, or an experienced few might occasionally speculate on foreign exchange or commodities. But structured products have changed that.
There are literally millions of structured products, typically created by banks to offer a specific type of return. They use derivatives to give investors exposure to underlying assets such as equity prices, interest rates, exchange rates, indices, credit spreads, funds, commodity prices – anything for which there’s a financial market.
The beauty of structured products is that they allow investors to take a nuanced approach to investing. Think of an investment in equities with the reassurance of capital protection in today’s volatile markets. Or an investment that enhances fixed income yields despite the past few years’ low interest rates. Or an investment with a hedge against currency risks at a time of fast-moving currency adjustments.
Through the flexibility of their derivative building blocks, structured products essentially offer pre-packaged investment solutions. Consequently, the sector has grown fast from its beginnings in Europe in the 1990s, quickly catching on in Asia and then the US. While little is written about the sector, it’s thought to rival the USD 3 trillion hedge fund industry in size.
Four broad types
In the most simplistic terms, there are four types of structured products, although there’s a huge variation on each:
- Capital-protected products
Capital-protected products participate in the performance of a financial asset like a stock, fund or index, while protecting the investor’s capital. Depending on the product, they may participate to varying degrees in the underlying asset’s upside and protect the capital either entirely or partially. - Participation Products
Participation products provide the possibility to participate in the performance of an asset or basket of assets. These assets could be anything, from equities, funds, bonds, ETFs indices to a mix of those. The most common participation products are tracker certificates; they provide 1-to-1 participation to the performance of a basket of securities. - Yield enhancement products
Yield enhancement products are recognized by the fact that they provide a predefined yield in return for a downside risk. Well-known products in this category are reverse convertibles. Those products provide the investor a predetermined yield per annum in return for the willingness to absorb downside risk of for example a stock, index, currency-pair or fund. Reverse convertibles come in a broad range of variations (with or without barrier, multiple underlyings and/or callability). - Leveraged products
Compared to the yield enhancement products, leveraged products provide a further enhanced yield, often without any limit to the upside participation. Leveraged certificates are examples of leveraged products; they provide enhanced participation to an underlying with inbuilt leverage. Leveraged exposure is also provided on the downside performance of the underlying. Therefore those products usually come with a stop-loss in order to limit potential capital losses. Another example is a call warrant, which is simply a call option that is traded in a securitized format. This format is interesting in order to be able to trade a call option on underlyings for which no exchange traded option market exists.
Tax efficiency
Often, products are structured to deliver the highest after-tax returns. For example, if a structured product can be engineered to generate a capital gain rather than income, as capital gains are not taxed so highly in many countries. Packaging a structured product as an insurance policy can also help tax efficiency.
Targeting rewards, controlling risks
The structured products mentioned above are among the simplest. They can get far more complex, offering experienced investors highly sophisticated ways to speculate on or hedge any financial asset, currency or commodity. Investors must fully understand the characteristics before investing in one, though, to be sure that they know what they’re buying.
They offer a wider set of investment opportunities than any other type of investment. And, they can be used for practical purposes such as adding diversification to an investment portfolio, hedging currency risk and even helping to manage cash flows.
Without doubt, structured products add another dimension to investing. They offer solutions that can be adapted to the needs of each investor, for example in terms of strategy, risk/return profile, maturity or the amount to be invested. Above all, they allow investors to target the specific rewards that they want and to adjust the risks they’re prepared to take.