Investment bankers and financial institutions have become very creative in the structured products they design.
Essentially, these products are designed to meet investor demand. Special features are often added that may relate to risk and return, such as principal protection, while some are arranged to distribute tax efficient income.
Nearly all of them have a targeted investment objective.
Structured products are generally a pre-packaged investment strategy that may include a combination of investments and derivatives. The structure is generally linked to the performance of an underlying security or basket of securities. The structure is generally linked to the performance of an underlying security or basket of securities.
Every structure is different and some may hold domestic investments while others are linked to foreign investments. Some structures may be linked to direct holdings, other funds and indices. Often, the linked investments may be combined with derivatives making structures more complicated to understand. Typical types of derivatives include options, forwards, and swaps.
Rather than explain the mechanics of derivatives we will explain the main reason why they exist. Derivatives exist to enable the transfer of risk from those who do not want to bear the risk to those who do. In other words, some investors may use derivatives to reduce risk (for a fee), while others may use them to increase risk and the potential for return.
So, how are they used? Structured products are generally an alternative to a direct investment. When people get excited about an asset class or a specific type of investment then financial companies are likely to respond by creating a structured product to meet the investment demand. Structured products may be added to a portfolio for a number of reasons, to provide diversification, exposure to different asset classes and geographies. Investors may find them appealing because they provide lower correlation to other investments within a portfolio. Simply put, they react and perform differently to various market conditions. The products that offer some form of protection may provide a method of managing downside risk. As noted above, many structured products provide tax-efficient income.
During the technology boom of the late 1990’s many people were following financial news and seeing incredible gains in this sector. Sophisticated and unsophisticated investors wanted to buy technology. Financial firms responded by setting up technology mutual funds and other structures linked to technology.
Many investors want to preserve their capital, but even more so after the tech bubble and 9/11. Around this same time, fixed income investments, such as bonds, were barely staying ahead of inflation and taxes. Financial firms responded quickly by offering financial products with equity exposure and principal protection.
Prior to the federal government’s “tax fairness plan” announcement on October 31st, many investors were excited about income trusts. Several structured products were created to hold a basket of income trusts and provided investors an easy way to obtain diversification within this type of equity investment.
Some companies have developed income and segregated funds that are more complicated than previous series. Some of these funds are focused on creating retirement income and have different features that individuals should fully understand prior to making an investment.
Some structured products are very interesting to read about. Take the recent “infrastructure funds” as an example. The average investor cannot simply go out and buy a road or bridge. Some of these structures allow individual investors access to these types of asset classes that have primarily been reserved for private equity and pension plans.
New structures are continually being created. Many of these structures may provide investors access to international investments. Other funds may have specific objectives including uranium funds, water funds, socially responsible investing, etc. A key point to remember is that with some types of investments or asset classes, structured products may be the easiest way to gain access.
Who uses Structured Products?
Although heavily marketed to the retail investor, they extend to all individuals regardless of net worth. Investors with small accounts may be attracted to the low minimum amounts required for most structured products. Hedge funds are generally targeted to the high net worth individual.
Understand the Structure
Regardless of the amount people would like to invest, or their level of sophistication, it is important to understand the structure before making a purchase. This understanding should include how the investment objectives of the structure fit into your overall plan. Take a detailed look at the risks and rewards, fees, and liquidity. Comparing structures issued by different companies may soon reveal the different options available. A complete understanding of the investment is also necessary to monitor the ongoing performance.
We caution all investors to only consider purchasing structures they understand and are suitable for their plan. We recommend avoiding investments you do not understand. From time to time you may miss out on a good opportunity, however, successful investing also involves avoiding poor investment decisions.