20 October 2022.
Understanding Structured Investment Products: How it works, the benefits, risks, payouts and why you should consider including it in your wealth portfolio
Since the wave of financial crises in the late 2000s, structured investment products have persistently adapted to an increasingly demanding economic, legal, regulatory and fiscal environment. Yet, at the same time, these sophisticated products have maintained a prime position in the portfolios of investors who seek exposure to equity markets but also require partial or complete capital protection if these markets fall.
Structured investment products are an exciting alternative to direct financial assets as they can be customised to match various market expectations, risk profiles, and investment classes.
Each year various insurers and investment companies issue numerous local and offshore structured investment products, each with its underlying characteristics.
Our wealth managers analyse these structured investment products and pro-actively advise our clients to consider such if we find such is suitable to their risk profile and performance objectives. This article explores structured investment products and questions you might have of it as an investment vehicle.
Why Consider A Structured Investment Product?
Selectively incorporating structured investment products into your investment portfolio can help you meet your financial goals, whether you seek to pursue a defined investment outcome, gain exposure to an asset class, or hedge existing positions.
Here are several ways in which you can use them to diversify, balance or enhance your investment portfolio:
Strategic: Structured investment products effectively implement strategic medium-term protection in your investment portfolio without deviating from your long-term strategy. In most cases, structured investment products offer the potential for enhanced returns while providing some degree of downside protection, potentially improving a portfolio’s efficiency.
Tactical: You can use structured investment products to express a market view on an asset without directly bearing the entire risk of exposure to the asset class. If you consider an asset undervalued (or overvalued), a structured investment product can express that view while potentially protecting some of the principal.
Manage Risk: Structured investment products may offer a way to reduce risk by increasing downside protection in a portfolio over a specified time frame. Depending on the chosen product, you can protect some – or all – of their principal, subject to an issuer’s credit risk.
Yield Enhancement: Structured investment products can also monetise volatility. You can focus on employing volatility as the underlying driving factor for a specific asset class in pursuing yield.
Market Access: Structured investment products provide individual investors, like you, with an option to access a diverse array of asset classes, such as equities, commodities and currencies, which were primarily only available to institutional investors.
How Do Structured Investment Products Work?
Structured investment products can be tied to various underlying assets, vary in term lengths, and include protection options. Investors also seek the level of return, or yield, when using structured notes.
A simplistic explanation of how structured investment products work
A securitised note is issued that tracks one or more market indices (local and global) where the issuer feels it can benefit from certain anticipated market conditions over a fixed term.
The issuer raises the required capital for the investment and, in exchange, offers investors certain benefits, the most notable being full or partial protection of the original capital amount invested.
The structured investment product promises to pay the investor “X” if the investment achieves “Y” at the maturity date.
If “Y” is not achieved (Y1), the investor receives their original capital (X1). In most cases, the “Y” amount represents the growth of the asset on a one for one basis
Some structured investment products offer less capital protection in return for higher returns; however, if the notes return is negative, the investor participates one for one on the downside.
The structure works in two parts:
Part 1 (Return of initial capital)
The issuer uses a portion of your investment to purchase an investment that will guarantee your initial capital at maturity regardless of market performance.
Part 2 (Investment growth)
The remaining portion of your investment is exposed to the underlying indices to capture positive market returns over the investment term.
Do Structured Investment Products Match Your Risk Tolerance?
Risk tolerance refers to the amount of loss an investor is prepared to handle while making an investment decision and is determined by various factors, e.g. financial goals, age, portfolio size, etc.
Structured investment products can also be classified according to specific risk profiles. While conservative investors may opt for a higher level of capital protection with a corresponding lower eventual investment return, more aggressive investors might be comfortable with less capital protection and a higher level of growth participation. They may even wish to leverage their upside to yield outsized returns if the market provides a particular result.
Types of Structured Investment Products and their level of risk exposure
pital protected structured investment products may be appropriate for investors who:
- are looking for a simpler and less risky investment
- want 100% protection of their capital at maturity
- do not mind locking up their capital for a certain period (e.g. from 1 to 5 years
hanced yield structured investments may be appropriate for investors who:
- are willing to risk the loss of some – or all – of their capital in return for an above-market periodic yield. In some cases, this yield may be contingent and therefore is also at risk
- have a neutral to moderately bullish view on the underlying asset
- are willing to forgo returns based on any appreciation of the underlying asset
Leveraged performance structured investments may be appropriate for investors who:
- are interested in generating returns beyond those available in moderately rising or range-bound markets
- can take on full or partial downside risk and can sustain a partial or total loss of principal
- seek to diversify their portfolio by gaining exposure to a variety of underlying asset classes
- are willing to accept an investment with a maximum payout at maturity
How Do Structured Investment Products Make Money?
Some structured notes with principal protection make periodic interest payments while others don’t. Over and above any principal guarantee and assuming you hold the note to maturity, the return on your investment will depend on a host of factors. These can include the method the issuer uses to calculate gains (or losses) linked to the performance of the underlying asset, index or benchmark (the “market-linked” returns), the note’s participation rate and any minimum guaranteed return. Below we outline some of the influencing factors:
Market-linked gains (or losses)
There can be varying and often intricate methods of calculating a market-linked gain or loss. For example:
Point-to-point
The product compares the change in an index at two discrete points in time, such as the beginning and end dates of the note’s term.
High water mark
The product might look at the index value at various points during the life of the investment, for example, at annual anniversaries, and then compare the highest value with the value of the index level at the start of the term.
Accrual or Range
Some products base your return on the number of days during the holding period that the underlying index stayed above (or below) a pre-specified level (accrual) – or within a range of pre-specified levels (range).
Shark fin
And still, others use complex, conditional formulas that allow you to participate in some or all of the index’s gain up to a set level – but significantly limit your return if, at any time during the holding period, the index rises above that level.
Participation rates
A participation rate determines how much of the gain in the underlying asset, index or benchmark will be credited to the note. For example, a product with 100% participation will pay 1% for every 1% growth in the underlying. Typically products that are ‘geared’ will have a participation rate above 100%; for example, 150% gearing on the FTSE 100 would mean that for every 1% the FTSE 100 increases, the return to you would be 1.5%.
How Easy Would It Be To Sell Your Structured Product If You Need The Money Right Away?
Structured investment products tend to be longer-term investments and are designed to be held until maturity for capital protection to apply. You may incur unwinding costs or face reinvestment risk and loss should you want to redeem your shares before the maturity date.
Some issuers might allow investors to redeem their notes before maturity under certain circumstances, such as the expiration of a “lock-up period” (during which you cannot access your funds) and payment of a redemption fee or both. Other issuers might (but are not obligated to) provide a secondary market for certain notes. However, depending on demand, the notes might trade at significant discounts to their purchase price and might not return the full guaranteed amount.
What Are Specific Risks Associated With Structured Investment Products?
Although structured products offer a degree of capital protection, no investment (including any structured product) can be regarded as free of all risk. Here are some of the key risks and considerations you need to be aware of when investing in structured products:
Issuer Credit Risk
As corporate debt, all terms, including the return of capital, are subject to the issuer’s credit risk.
No Direct Ownership
Investment in a structured note does not provide the investor with ownership rights in the underlying asset, such as dividends and voting rights.
Fixed and Capped Investment Returns
Structured notes which have defined coupon payments, or upside potential limited by a step-up return or a maximum gain, may underperform relative to a direct investment in the underlying asset.
Tax
Regarding taxation, structured products are generally subject to Capital Gains Tax (CGT) or Income Tax.
Exchange rate and control risk
Where the structured product is denominated in a non-local currency, you face the risk of exchange rate fluctuations (where applicable). This may affect the applicable exchange rate and result in the receipt of reduced coupon(s), cash settlement amounts and / or a loss of principal when converted to your local currency and make it impossible or impracticable for the issuer to pay you in the original settlement currency. Exchange controls may also apply to the currencies your investment is linked to. A government may, sometimes with little or no warning, impose exchange controls or other monetary controls. Such measures may significantly affect a currency’s convertibility or transferability, which might have unexpected consequences for the structured product.
How Are Fees Managed In A Structured Investment Product?
In most cases, the fees are contained in the note’s price and paid once-off, ensuring that the structure can participate in the market on an unfettered basis without incurring harmful costs during the term.
Costs and fees are usually fully priced into the structured investment product. If the structured investment product offers you, for example, a possible cumulative return of 45%, this is expressed net of all fees and based on the initial investment amount. Any costs will typically be paid as an upfront fee to the service provider concerned, usually at the start of the investment term. However, as mentioned, these fees are built into the product. They will not affect the outcome of your investment or reduce the initial investment value on which ultimate returns are determined.
Conclusion
Structured investment products encompass a variety of vehicles that can be used to pursue a defined investment outcome, express a market view on a specific asset class, or hedge an existing exposure.
Once the exclusive province of large institutional investors, structured investment products are now available to individuals and are an additional investing tool that can help them realise their financial goals. As such, structured investment products are increasingly essential components of high-net-worth investors’ portfolios.
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