There’s No Such Thing as a Free Lunch–Looking Under the Hood of Structured Products

Written by: Christian O’Dwyer, CFA | Vice President

Investors should always be wary of promises of risk-free returns from their advisors and the products they recommend or sell. All investments carry a degree of risk, except for those rare cases of pure arbitrage. Successful long-term investors find opportunities where risk is garnered only when it is accompanied by a commensurate return. Structured products, which are typically designed and issued by financial institutions and sold by broker-dealers to individual investors, are a good example of strategies that frequently promise upside market participation alongside capital preservation. This article reviews the definition of structured products, how they work, how to analyze them, and their role in a diversified portfolio.

What Are Structured Products?

Typically, structured products are debt securities with a fixed maturity and include two components: a bond component and a derivative component. The bond portion of the note is the majority of the investment and provides principal protection. The embedded derivative may be linked to the performance of an asset, index, a single equity security, a basket of equity securities, interest rates, commodities, and/or foreign currencies. The notes are used to modify market exposure, or otherwise manage market risk, credit risk, or both. The type of derivative embedded in the note will affect the performance characteristics of the note and the complexity of performance calculations. The products typically employ a degree of leverage.

How do Structured Products Work?

The below image provides an example of a theoretical structured note. Consider a simple, three-year, S&P 500 index-linked structured note with 100% principal protection promising preservation of capital, 80% participation with the index and a capped return of 20%. The various return scenarios are depicted:

How to Analyze Them?

While our example was (hopefully) useful from a conceptual standpoint, it was very basic as compared to most structured products in the market. As features are added to the products, complexities mount making appropriate levels of due diligence more difficult. In response, the U.S. Securities and Exchange Commission issued a 2015 bulletin that plainly stated, “While structured notes may enable individual retail investors to participate in investment strategies that are not typically offered to them, these products can be very complex and have significant investment risks. Before investing in structured notes, you should understand how the notes work and carefully consider their risks.” Additional considerations are listed below.

• Know the fees and other costs associated with the investment.

  • Structured notes are highly complex and carry low fee transparency; it is important to fully understand both the stated and embedded costs associated with the product.

• Know whether the product is appropriate for the intended investment objective.

  • Are the risks associated with a particular structured note within your tolerance for risk, or are your investment needs better served by investing in another product?

• What other investment choices are available to me? Are other products available that provide investment exposure to similar assets, indices or strategies? If so, how do the costs of these other products compare to those associated with the structured note?

  • Carefully consider what might be a suitable investment for you, and whether there are better alternatives to the structured note you are considering. For example, can I purchase some or all of the components of the structured note separately for a better price?

• How long will my money be tied up?

  • Many structured notes are meant to be held to maturity. If you need your money back prior to maturity, you could lose a significant portion of your investment.

• Are potential returns limited?

  • Some structured notes have caps on the returns that can be earned based on the performance of the reference asset or index. This is an example of a potentially significant embedded cost.

• What is the credit risk of the issuer of the structured note?

  • Remember that any payoff on a structured note is subject to the creditworthiness of the issuer. Be sure to understand the financial condition of the issuer and read its disclosures as carefully as you would for any other investment.

For more information, please visit: https://www.sec.gov/oiea/investor-alerts-bulletins/ib_structurednotes.html

What is the Role of Structured Products in a Diversified Portfolio?

While the capital preservation feature and the customization of structured products can make them attractive for potential investors, the complicated payoff profile, opaque expense structure, lack of liquidity, and associated credit risk decrease their usefulness within a broad portfolio context. Investors should also consider opportunity costs associated with forgone investments in their overall strategy. In sum, the time-tested qualities of remaining patient, keeping costs low and being well diversified are most likely to drive long-term investment success.

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For more than 20 years, Innovest has provided excellent client service as well as forward-looking, innovative investment solutions for endowments and foundations, retirement plans, and families. We are an independent provider of investment-related consulting services and work on a fee-only basis.