"Structured products are created to meet specific needs that cannot be met by standardised financial instruments available in public equity and debt markets".
- Jeel Shah,Portfolio manager, Niveda Wealth LLP
Once upon a time in the early to mid 1900s, the financial world was a quiet place where a small number of money managers developed portfolios for their clients within a narrow defined range of high-quality debt and equity products. However, financial and technological innovation changed all that.One particular innovation that has gained traction as an addition to institutional as well as retail portfolios is the asset class known as structured products. Structured products offer retail investors easy access to derivative securities.The U.S. Securities and Exchange Commission (SEC) Rule 434 defines structured securities as “securities whose cash flow characteristics depend upon one or more indices or that have embedded forwards or options or securities where an investor′s investment return and the issuer′s payment obligations are contingent on, or highly sensitive to, changes in the value of underlying assets, indices, interest rates or cash flows”.Structured products are created to meet specific needs that cannot be met from the standardised financial instruments available in the public equity and debt markets. Structured products can be used as a substitute to a direct investment, as part of an asset allocation process to reduce risk exposure of a portfolio, or to utilize the current market trend and speculate.This is accomplished by taking a traditional security such as a conventional investment-grade bond, and replacing the usual payment features with non-traditional payoffs. These non-traditional payoffs are derived not from the issuer′s own cash flow, but from the performance of one or more underlying assets. The payoffs from these performance outcomes are dependent in the sense that if the underlying assets return "x" then the structured product pays out "y".This means that structured products closely relate to traditional models of option pricing, though they may also contain other derivative types such as swaps, forwards and futures, as well as embedded features such as leveraged upside participation or downside buffers.
There is no uniform standard for pricing a structured product. This makes it harder to compare the pricing attractiveness of alternative structured products and other assets. Many structured product issuers work the pricing into their option models so that there is no explicit fee or other expense to the investor. On the flip side, this means that the investor can′t know for sure what the implicit costs are.
Benefits of structured products may include:
- Principal protection (depending on the type of structured product)
- Tax-efficient access to fully taxable investments
- Enhanced returns within an investment (depending on the type of structured product)
- Reduced volatility (or risk) within an investment (depending on the type of structured product)
- The ability to earn a positive return in low yield or flat equity market environments
Disadvantages of structured products may include:
- Credit risk - structured products are unsecured debt from investment banks
- Lack of liquidity - structured products rarely trade after issuance and anyone looking to sell a structured product before maturity should expect to sell it at a significant discount
- No daily pricing - structured products are priced on a matrix, not net-asset-value. Matrix pricing is essentially a best-guess approach
- Highly complex - the complexity of the return calculations means few truly understand how the structured product will perform relative to simply owning the underlying asset
Structured products can bring many of the benefits of derivatives to investors who otherwise would not have access to them. However, at the same time these products were once described as “Financial weapons of mass destruction” by none other than Warren Buffett.The risks and transparency issues involved with such products keep most of us away from structured products. It helps us remain conservative and also safeguard ourselves from financial crises.
Jeel Shah is portfolio manager at Niveda Wealth LLP, an investment partnership that follows a conservative, value-investing approach with a long-term investment horizon.
The above article was published in
launched in April 2014 in conjunction with the
