Alternative investments include assets outside the traditional classes of equities and bonds. Structured products are one of the most complex investments in this category. This investment is particularly challenging to understand fully because it is a customized mix of other assets meant to meet specific investor needs. Often, structured products include the use of derivatives.
Investment banks created structured products for a wide range of customers, including hedge funds, organizational clients, and individuals. When creating these products, specific goals and needs are weighed to make a custom investment for the client.
What Exactly Is a Structured Product?
Structured products can vary greatly in terms of scope and complexity depending on the expectations of the client and overall risk tolerance. In general, a structured product will expose you to fixed income markets and derivatives. Typical structured products will start with a traditional security like a certificate of deposit or investment-grade bond. Then, the usual payment features are replaced with new types of payoffs that depend on the performance of underlying assets rather than the cash flow of the issuing party. A very simple structured product, for example, may be a certificate of deposit that does not have interest payments but instead pays yearly based on the performance of a particular stock index. If that stock index rises, the investor earns money. If it falls, the investor still gets back the initial investment when the certificate of deposit ends.
Investors are attracted to structured products because they can offer exposure to different markets and drive diversification. For example, a rainbow note is a structured product that exposes investors to more than one underlying asset. Rainbow notes can derive value from assets that are not very related to each other, such as indexes in different countries or that follow different types of investments. This can reduce volatility since diversification is built into the investment itself, especially if it has a lookback feature. With this feature, structured products use the optimal value of an underlying asset over a certain period rather than the final value at expiration. However, these types of structured products can become extremely complex.
The Benefits and Drawbacks of Structured Products
The primary advantage of a structured product is the diversification it offers, which is much more than you get with a typical asset. The other benefits of these products typically depend on the exact type of investment, as they vary so much. However, depending on your needs, you can protect your initial principal, minimize tax burden, lower overall volatility, or maximize returns when compared to the underlying assets. In addition, these products can be used to generate positive yields when the overall market is not performing well. While one product would not provide all of these benefits, you can choose what means the most to you based on your goals and your existing portfolio.
While the advantages of a structured product can be exciting, the drawbacks are significant. One of the biggest is the complexity of the product, which can expose you to risks you do not even realize. Beginning in 2018, the Securities and Exchange Commission has been stricter with structured products due to a lack of transparency. That same year, a major firm paid out $4 million after it was found that representatives were encouraging investors to buy and sell a structured product intended to be held until maturity. In turn, these representatives earned huge commissions while investor returns were reduced. The increased scrutiny has improved the environment, but investors still need to recognize that there is risk in the complexity of these products.
Beyond that major disadvantage, the fees associated with structured products can be very high. Furthermore, these fees can be hidden within the payout structure of the investment or in the charges associated with entering and exiting positions. In other words, you may not even realize how much you are paying. Plus, there is some credit risk with the bank backing the structured product. Issues with this bank could affect your payout. You may also struggle to sell the product if you want to exit before maturity, so they are not a great option if you need liquidity.
The Bottom Line
Structured products can provide a unique sort of diversification for investors and offer many other advantages depending on individual needs. However, you will likely pay high fees for these advantages. Because these products can get very complex, it is important to read the fine print and understand exactly what the investment entails. You may need some professional assistance clarifying points about it. Some banks use structured products primarily as a way to drive profits, so it is important to approach these investments with some healthy skepticism and do your homework before investing.