Structured products

Structured products are synthetic investment instruments specially created to meet specific needs that cannot be met from the standardized financial instruments available in the markets. Structured products can be used: as an alternative to a direct investment; as part of the asset allocation process to reduce risk exposure of a portfolio; or to utilize the current market trend.

A structured product is generally a pre-packaged investment strategy which is based on derivatives (ie. options and to a lesser extent, swaps) but which features protection of principal if held to maturity. For example, an investor invests 100 dollars, the issuer simply invests in a risk free bond which has sufficient interest to grow to 100 after the 5 year period. For example, this bond might cost 80 dollars today and after 5 years it will grow to 100 dollars. With the leftover funds the issuer purchases the options and swaps needed to perform whatever the investment strategy is. Theoretically an investor can just do this themselves, but the costs and transaction volume requirements of many options and swaps are beyond many individual investors.

Understanding Structured Products

Once upon a time, the retail investment world was a quiet, rather pleasant place where a small, distinguished cadre of trustees and asset managers devised prudent portfolios for their well-heeled clients within a narrowly defined range of high-quality debt and equity instruments. Financial innovation and the rise of the investor class changed all that.
One innovation that has gained traction as an addition to retail and institutional portfolios is the class of investments broadly known as structured products. This article provides an introduction to structured products with a particular focus on their applicability in diversified retail portfolios.

What are structured products?

Structured products are designed to facilitate highly customized risk-return objectives. This is accomplished by taking a traditional security, such as a conventional investment-grade bond, and replacing the usual payment features (e.g. periodic coupons and final principal) with non-traditional payoffs 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 contingent 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.
Structured products originally became popular in Europe and have gained currency in the U.S., where they are frequently offered as SEC-registered products, which means they are accessible to retail investors in the same way that stocks, bonds, exchange-traded funds (ETFs) and mutual funds are. Their ability to offer customized exposure, including to otherwise hard-to-reach asset classes and subclasses, makes structured products useful as a complement to these other traditional components of diversified portfolios.