Structured products: Articles

This area of the site examines the ways in which underlying investments can be ‘structured' in such a way as to enhance performance, protect against potential losses, minimise taxation and legal obligations, or even reduce fees.

This area of the site examines the ways in which underlying investments can be 'structured' in such a way as to enhance performance, protect against potential losses, minimise taxation and legal obligations, or even reduce fees. Banks and fund managers are constantly devising new products, frequently of increasing sophistication and decreasing transparency, for both the corporate and retail marketplace. As a high net worth investor, you may be able to get exposure to both.

At Fintactica we split the structured products market into two: firstly those products that are developed by investment banks, primarily for institutional consumption, and which can sometimes be found trading on major exchanges, and secondly 'packaged' investments that are frequently offered to private investors, but which will often have some kind of built-in derivatives exposure, or will be tax-efficient in some way.

Both kinds have been around for some time, and range in sophistication from an offshore capital guaranteed bond, to the latest derivative-based trading programs that seek to control volatility (unpredictable fluctuations) in an investment.

Securities-based and derivatives-based structured products are a major growth area in the wealth management industry at the moment. As a client of a private bank or sophisticated financial adviser, you will likely have already been offered investment schemes that are 'structured' in some ways.

Such products can be useful to investors, but whereas they will frequently seem the less-risky option when compared with direct investments into securities, they will often require you to tie up a substantial amount of capital with the provider, be it a fund manager, international insurance office, or private bank. There may be the option available to get out early, but substantial penalty fees will be linked to this. Some providers do maintain secondary markets in their products which will allow you to sell them on, so it is worth asking about this if you suspect your investment time horizon will be shortened.

Be sure to measure the likely performance of the investment against what you could do with it otherwise, including putting it in safe-haven investments like US government bonds or even a high-interest savings account with a major bank. Bear in mind also the potential impact of inflation on the purchasing power of your investment during the period it will be tied up. Structured products will not necessarily give you superior performance to simply leaving money on deposit. Analyse them on a case-by-case basis.

Some of the most sophisticated structured products may also be offered to family offices and the portfolio managers of extremely rich investors. It is important when taking any exposure to these to appreciate what downside risk might exist. With some derivative-based structures it is possible to lose more money than you invested. Make sure your adviser builds in some degree of downside protection. If you're not happy with this, don't be afraid to seek a second opinion.

Guaranteed Products

Guaranteed or protected products are investment schemes that promise to protect a percentage of the value of your investment (usually 95%-100%) plus offering you additional returns based on an underlying performance barometer, usually a stock-market index, basket of stocks, or portfolio of funds. Some structured products, called equity-linked deposits or equity deposits, are linked to underlying securities. All guaranteed products of this kind will have a pre-determined life, with a specific maturity date at which they will pay out.

The attraction of guaranteed funds is that you will get your investment back (usually), the downside is that the capital is tied up until the maturity date, usually several years into the future, and you will not benefit from the full gain in the underlying security. Some funds will even offer guaranteed returns: they will achieve this by putting the bulk of the cash on deposit in high interest accounts, or in low-risk government bonds, then use the rest in an aggressive trading strategy, usually employing derivatives, to ensure the returns.

Evaluate each product on the basis of whether you could replicate the performance without using it. Many of the more basic guaranteed products do not require rocket science, particularly if you are happy using warrants (see below) to leverage upside exposure to an index like the FTSE or the S&P 500. Also ask yourself whether you can afford to tie up the cash involved for the period of time the product requires, and whether the index or securities portfolio its performance will be linked to are a good bet in the first place. You might think the S&P 500 looks good over two years, and is probably a good bet over 10 years, but will it look good over five?

Some banks will be able to offer you structured deposits, guaranteed products which provide you with more flexibility, in that you can take your money out when you want. But ultimately the attraction of these investments is that you can rely on the bulk of your investment being returned to you on the maturity date.

Warrants

These are derivative contracts that are increasingly being made available to private investors via brokers and private banks. They are highly liquid and freely tradable securities that function like options. They are linked to underlying securities like shares, or currencies, or even a specific index like the Standard & Poor's 500 (S&P 500) or the FTSE 100. They can be used to either augment the return you would get from holding an asset (like a share) or to protect against the possible decline in that asset's price.

With shares, a 'call' warrant will provide you with the right to buy a share at a specific price (the 'strike' price) on or before the exercise date (warrants have a limited shelf life - the exercise date is the final day on which you can 'exercise' this option). If the share price did climb, you could either sell the warrant at a higher price than you bought it, or use it to acquire the share it is linked to at a lower price than it is currently trading, and thereby make a profit on the difference.

A 'put' equity warrant lets you sell a share at a fixed price, and can be used to insure against potential losses, or indeed to directly benefit in the fall of a stock price.

Structured Portfolios

Unlike the higher risk derivatives-based products described above, this area of the site also covers what we categorise as 'structured portfolios', namely a portfolio of securities or investment funds which can be congregated under a single umbrella in order to achieve taxation or legal advantages. Such portfolios can be highly individual, depending on the product you choose. For example, some providers will provide you with a menu of funds to choose from, while others will allow a virtually unlimited range of investments to be held, including real estate and portable assets.

When choosing a structure for your portfolio, it is important to take legal and taxation advice that evaluates your individual circumstances. Also be aware that many of these products are sold by financial advisers who earn high levels of commission for attracting clients to invest in them, regardless of their suitability. Always seek independent advice before making an investment of this kind.

Investment Bonds

An investment portfolio can be tied to a life insurance policy. The main incentive for doing so is the tax deferral advantages which can accrue as a result. This can confer a considerable advantage taxwise against a convential portfolio of funds, but the advantage of buying an investment bond must be judged against your own personal tax circumstances. For example, tax deferral is available in many European Union countries. Check with your tax adviser before buying an investment bond, as depending on your nationality and residency, there may not be any advantage in using one.

Investment bonds are graded according to the choice of underlying investments available via the bond. Basic collective bonds will usually offer a menu of up to 300 funds, many of which will be 'mirror' funds that track the precise investment activity of a fund managed by a specialist fund management group, but which will bear the brand of the original bond provider. Increasingly sophisticated versions will offer a broader menu of funds from third party managers, right up to a broadly-diversified portfolio, including shares, funds, currency deposits, and bonds.

Investment Wraps

For some years now there has been a major offshore market in the sale of products that 'wrap' an underlying portfolio of investment funds into a single legal structure. Wraps have the benefit of providing the investor's fund portfolio with the flexibility to meet current and future tax planning demands in multiple jurisdictions by congregating them under a single structure. This product does not have the additional life-linked characteristics of the investment bond (see above) and could be more suitable for investors who cannot benefit from the tax efficient characteristics of the investment bond.

ETFs

Exchange-traded funds are very low-cost funds that trade on major stock exchanges in the same way as a share would. ETFs track a specific stock market index like an index-tracker fund would (see the Mutual Funds section for more on index-trackers), but are much easier to buy and sell than a normal fund. By buying an ETF, you are effectively buying the index with one transaction.

ETFs are passive investments: the companies they invest in are pre-determined by the provider of the index. They are a cheap and efficient way to benefit from the performance of a large portfolio of quality stocks via a single investment. You can buy ETFs via a stockbroker or private bank, or from wherever you are able to buy shares.

We have included ETFs in the structured products section rather than the mutual funds area because they are effectively stock portfolios that have been structured in an original way in order to provide investors with specific advantages, namely liquidity (fast and cheap to buy and sell) and lower fees relative to actively managed funds.

Conclusions

This introduction is really only the tip of the iceberg in terms of the broad range of structured products currently available to the private investor. Not all of them will be suitable to your requirements. Frequently investors commit to a given investment or portfolio structure, only to find that some years later it conflicts with future financial and investment objectives. Be particularly clear on whether any penalties exist for early exit, and whether there are any potential downside risks, especially when taking derivatives exposure. If uncertain, seek a second opinion from a qualified financial professional.