In the lingering aftermath of the global financial crisis, many individuals are hesitant to invest their money in fear of losing what little remains. For these investors, and others, structured products allow one to receive a portion of the upside benefit of making an investment while simultaneously protecting against the bulk of the downside risk.
An Introduction to Structured Products
A structured product is designed to give an investor some participation in the upside of a potential investment, while protecting against loss by intending to repay the principal investment at maturity.
These products often sound complex, and it can be quite confusing to fully understand what participation and protection is actually offered. Since the majority of structured products have a term structure, meaning your money is locked up for a set period of time to avoid costly penalties, it is critical to make a thorough evaluation before committing capital.
The two primary classes of structured products are:
Structured capital-at-risk products (SCARPs)
These require the investor to risk some or all of his or her principal, but offer the highest upside participation rate in the underlying investment.
Principal protection products
These are designed to return the entirety of the investors principal at maturity regardless of the performance of the underlying investment; these types of products offer more protection but have lower participation rates.
The result of the diversity of structured product types is that an experienced investor may target any part of the risk/ reward curve the he chooses, taking greater risk in SCARPs or less risk in principal protection products. Another option is to employ an asset allocation approach and spread one’s investment across multiple products.
This increased diversity offers an additional layer of protection, but it is critical to remember that the solvency of the investment firm is paramount; if the firm becomes insolvent, even an investor in principal protection products may lose his investment.
What is a Structured Product?
The purpose of a structured product is to provide principal protection while still offering upside potential on an investment. To achieve this end, the investment typically contains two elements: a principal piece and an investment piece. The principal piece is designed to just meet the principal obligations of the product.
For example, if the product promises to repay all of one’s principal at the end of the ten-year maturity, the principal piece might invest in a zero-coupon bond that will pay the full amount at the same maturity date. In this way, the manager can “guarantee” that the full amount of the principal will be available at maturity. The remaining portion of the capital is placed into the investment piece.
If the product is designed to track a percentage return of a major stock index, the remaining capital may be used to buy futures or ETF shares.
The reason that the product only pays a percentage of the return of the index is that the remaining capital, after fees, is insufficient to duplicate the full performance of the index. The investor gets a portion of the performance, but has the comfort of additional protection.
Common Plans
* Maximum Returns
Under this type of plan an investor’s upside, as well as his downside is limited. This means that if the index rises by more that the predetermined percentage, the investor forfeits the additional profits. This is the price of the protection because if the index falls, he still receives back his original capital at the maturity of the investment.
*Minimum Returns
Under this type of plan, the investor is guaranteed a minimum return. In some cases, he may receive this only of the index is above the price it was when the investment was initiated, but most commonly the return is promised regardless of the performance of the index.
In other cases, if the index has climbed by greater than the minimum return, he may participate at a fixed rate. For example, the product may promise a return of 15% if the index is up, and an additional 50% of the upside if the index has climbed by greater than 15%. If the index was down, only the principal would be returned.
*Defined Returns
Under this type of plan, the investor is offered a binary return structure. If the index is up, he receives a set return. If the index is down he receives back his principal.
In the case of a defined return, the manager is taking the risk that the return is positive, but below the defined return level.
SCARPS – Structured Capital-At-Risk Products
A SCARP is similar to the products discussed above, except that they have the potential for loss below a given threshold decline in the underlying investment or index. Below that level, the investor typically participates fully with the index return and may lose a portion or all of his or her money.
The reason for this trade off is that these products tend to offer greater upside potential in exchange for the additional risk.
It is generally a good idea to employ an asset allocation strategy and spread one’s investment across several products. Furthermore, it is advisable to select products backed by a variety of financial institutions, because the failure of the institution can result in no money being returned regardless of the product claims. Understanding the various product types is a critical element of investing in these products.
Issue That Should be Checked and Considered
The Financial Services Authority, the UK financial regulator, advises the practice of limiting one’s total exposure to any given financial institution to 10% of one’s investable assets and to not place greater than 25% in structured products in total.
The duration of the investment, including both the maturity and the lockup period. Furthermore, if there is a penalty for early withdrawal, it is important to understand the specific dynamics of the penalty.
It is important to consider the nature and characteristics of the underlying index or asset to be invested in. Given varying levels of volatility, this can have a dramatic impact of one’s return.
The precise level of protection being offered, as well as how and by whom it is determined.