What are structured products?

At their core, structured products are customised investment solutions built by combining two familiar building blocks: a classic investment (such as a bond) and a derivative financial instrument (such as a call option) linked to the performance of an underlying asset. A product can be designed to fit any market expectation (positive, stagnant, or negative) and any risk profile (conservative, balanced, or aggressive).

This flexibility is achieved by choosing an appropriate derivative strategy. For example, rather than buying a stock directly, one might buy a note whose return depends on whether that stock goes up, stays flat, or only drops slightly, and, in some cases, this can be combined with some level of downside protection. Investing in structured products is about expressing a view on how the underlying assets will behave, including the direction, stability, volatility, or even the correlation between them. Structured products consist of three elements: the underlying asset, the derivative instruments, and the payoff structure which together translate a specific market view into an investment outcome.

Three elements of structured products

1. Underlying

Investments such as equities, exchange-traded funds (ETFs), funds, interest rates, foreign currencies, or commodities are common examples of underlying assets for structured products. The performance of these underlyings is the main driver of how a structured product’s value evolves over time.

When selecting the underlyings, the starting point should be the investor’s outlook on the underlying asset. In addition, the investor’s objectives and risk tolerance should be taken into account. When choosing equities, it is also important that the stocks are appropriate given the structure of the product.

For structures with multiple underlying assets, it is important to consider not only the individual assets but also their correlation – how similarly the assets move relative to one another. 

2. Derivatives

Derivatives (options, forwards, and swaps) are the tools used to engineer the payoff features of a product, such as the protection levels and the upside participation. Volatility directly affects the daily market movements of derivatives and can be a powerful ally for many structured products that use derivatives as part of their construction. When markets are more turbulent, options become more valuable – similar to how insurance premiums rise when storms are on the horizon. Meanwhile, when markets are calmer, option premiums tend to be lower. When constructing a product designed to preserve capital in whole or in part, principal – that is, the initial amount invested – is used to purchase a zero-coupon bond. A zero-coupon bond pays no periodic interest but is issued at a discount, growing back to the target protection level (e.g. 95% or 100%) at maturity. The remaining budget is then used to purchase options, which determine the product’s payoff profile. Interest rates dictate how much of the principal must be allocated to the zero-coupon bond: higher rates make the bond cheaper, leaving more residual budget for options and therefore higher upside participation; while lower rates make the bond more expensive, reducing the budget available for options and thus lowering either the upside participation or the level of capital protection.

3. Payoff

The payoff is the mechanism that defines how the return of the product is generated. When choosing the payoff, the market environment and the investor’s objectives and risk tolerance should be taken into account. Most structured products can be grouped into four main categories: 

• capital protection
• yield enhancement
• participation
• leverage

Essentially, the potential return on an investment in a structured product is determined by a combination of these three building blocks – the underlying, derivatives, and payoff.

Why invest in structured products?

Structured products can offer investors a flexible way to gain exposure to a variety of markets, as they can be tailored to an investor’s market views, preferred underlying assets, risk tolerance, and investment horizon. This makes structured products a valuable option for both tactical ideas and longer-term strategies. Through the use of derivatives, they can provide forms of market exposure that direct investments cannot. Rather than a one-size-fits-all approach, products can be structured with customised risk and return profiles, depending on whether an investor is seeking capital protection, enhanced yield, or targeted exposure to specific market scenarios.

They can also be an efficient way to diversify a portfolio because, with different payoff structures, there are multiple drivers of returns in one product, such as equity market performance, interest rates, or credit spreads. As a result, the products often have non-linear payoffs, and this can mean that they have a low correlation to traditional assets, thus improving the potential diversification benefits in portfolios. Other solutions provide more linear payoffs, but these can be structured with a downside buffer or with leveraged upside participation. Another advantage is the fact that the time to market is short, so investment ideas can be implemented quickly.

Structured products can generate income, diversify across asset classes, and help express tactical views, all while potentially limiting downside. In summary, they can help to align an investor’s portfolio with their market outlook and financial goals.

Portfolio considerations when investing in structured products

When investing part of a portfolio in structured products, investors should assess how different payoff profiles align with their overall investment objectives and risk tolerance. Structured products offer a wide spectrum of risk-return characteristics: some provide capital protection or conditional downside buffers, making them suitable for reducing overall portfolio volatility, while others carry higher risk in exchange for enhanced return potential. Understanding this spectrum is essential, in order to select a product with a payoff that has the desired impact on portfolio risk.

Life-cycle management

Unlike equities, where investors typically follow daily price movements, structured products need to be monitored differently. It is essential to be aware of the credit strength of the issuer by monitoring updates from rating agencies. Investors in structured products are exposed to the issuer’s credit risk rather than holding the underlying assets directly. If the issuer were to default, investors could lose some or all of their capital, regardless of how well the underlying assets have performed.

Key risks

It is very important to fully understand the risks involved in investing in structured products before making an investment. The key risks to consider include:

• Credit risk/Issuer risk – By investing in a structured product, an investor is essentially lending money to the issuing bank. The risk that the issuer defaults is therefore something that the investor must consider. To assess this risk, investors can check the issuer’s credit rating. Overall, the best strategy is to ensure diversification across different issuers.
• Complexity risk – Given their unique and at times complex nature, misunderstanding the products and how the return is determined is in itself a risk – a good philosophy for investors to bear in mind is: ‘if you don’t understand it, don’t buy it’.
• Liquidity risk – Liquidity can be restricted in structured products when they are highly tailored or have longer maturities. The issuing bank often provides the only secondary market, and if the underlying assets do not trade frequently, this can further limit investors’ ability to exit positions easily.
• Market risk – Many structured products have intricate payoff mechanisms, where the return depends on specific market scenarios. Investors need to clearly understand how the product behaves in different scenarios. If the underlying market performs contrary to expectations, the structured product can deliver lower-than-expected returns or even result in losses.

Ultimately, structured products can be a valuable part of a well-constructed investment strategy, enhancing diversification, tailoring risk levels, and helping to achieve more precise outcomes. There are structured products that suit any scenario and any risk-reward profile, so the key is to find a product that makes sense given the current environment and that is also aligned with the investor’s broader risk and return profile.