The strength of structured products is their ability to reshape risk-return profiles away from linear outcomes.
Structured products open up a wealth of possibilities for investors who are not just looking for direct investment into an underlying asset. Simple conventional investments such as equities, bonds and cash form the basis of many portfolios and within this framework there are many ways to build wealth at different risk profiles and investor goals. Traditional investments are generally flexible, simple to understand and deal in and open ended in nature.
The two principal decisions that must be made in the selection of one or more structured products are the underlying asset and product profile
However so-called linear investments do not suit all investors, primarily because of a need to control risk and avoid losses to capital. The best that a conventional portfolio could do to address risk concerns would be to spread more of the assets into fixed income or other low volatility assets. An alternative would be to move more of the portfolio into cash thus reducing exposure to market performance further which will impact returns in rising markets.
Structured products were created to solve these problems in a fundamentally different way. The two principal decisions that must be made in the selection of one or more structured products are the underlying asset and product profile. Since structured products are what are termed “defined investments”, once these two choices are made the product return will be a precise combination of underlying performance and product payoff and not subject to any other uncertainty such as changing economic variables or fund manager performance.
Payoff types
The concept of product payoff is what makes structured products unique and in general they can be created with many types of underlying assets. There are some common constructions used in different structured product types, these include participation, cap, barrier, averaging and autocall points.
All of these features are used to create the breadth of payoff possibilities and here we will consider the relationship between underlying performance and product performance. Since structured products reshape the payoff and risk profile there will necessarily be differences in how the to the product return behaves compared to the underlying which must be understood by investors both before and after investing.
A simple example is the protected participation product. This has always been popular and was one of the first uses of retail structured products. Consider a product that pays perhaps 80% of the growth in an underlying, or 100% of the growth but subject to cap on returns of 180%. It also has full capital protection and does not pay any dividends in the underlying.
Since this product provides most of the market upside with full capital protection it combines characteristics of direct equity investment and cash deposits. The product will underperform direct equity in scenarios of strong market growth because of the presence of the cap or participation rate below 100% and because there are no dividends paid. If the underlying falls, then the product will maintain capital protection but will not necessarily pay any minimum return and therefore it will underperform cash. It is unfair to choose the benchmark after the product has matured, this is a trap investors or others sometimes fall into, arguably the fairest benchmark to capture both asset classes would be a simple portfolio of equity and cash perhaps at 50% weighting each.
Drivers of return
This simple alternative portfolio will never match the structured product in cases of strong market growth. It is therefore essential that an investor is made aware of the different drivers of return or potential underperformance versus either the underlying or cash.
While participation products remain prevalent yield generation solutions have become the biggest sector of the structured products market over many years, particularly given the low level of interest rates that has persisted making income alternatives very popular.
Income generating products tend to have more features in the product design which can come into play and therefore create the potential for investor confusion. Income products also generally have a headline yield which puts that figure firmly in the investors mind and any scenario where this is not achieved will need to be understood.
Any high-income product will necessarily have risk to either capital return or income payments. Capital risk is generally presented when the underlying falls, generally partially protected by a capital barrier. Any barrier will protect against some market downturns but will be a very binary event driven by whether the underlying falls below the barrier level either during the life of the product for an American barrier or at maturity for European. This exposure is further complicated for “worst-of” products where the investor may think the relevant underlyings have performed adequately because the based on the majority or average of them there is no perceived underperformance.
The most common structured product type in most markets for many years has been the autocall. These also have the potential to generate a disconnect between underlying return and product return. When the underlying performs very strongly the difference in the fixed return and underlying growth can be very apparent particularly in the early part of the product life, leading to impressions of underperformance and unwelcome early product termination. The best scenarios for most autocalls are very modest market growth or in the case of defensive autocalls even slight market falls.
The strengths of structured products are their ability to reshape risk return profile away from linear outcomes to better serve investors risk appetite and need to preserve capital. However, this strategy brings a need to understand how underlying performance translates to product success.
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