Reviewing Structured Products

Reviewing Structured Products- key features to look at and why they are important

Structured products are one of the most misunderstood investments. Indeed, it’s hard to name an investment that creates more unintentional confusion in the market – and this sometimes includes regulators. Many comments about them display either ignorance or prejudice – and sometimes both.

But it doesn’t have to be this way. In essence, a structured product is a repackaged financial product for the retail or institutional markets. In addition, they have a very long history. They have been around since antiquity. And for a very good reason – they provide a reshaping of investment risks and returns and can provide a known worst-case outcome.

So Instreet has set out an easy to understand guide to structured products that we hope will help clear up these misunderstandings. It is structured (no pun intended) under 14 topics ranging from the underlying asset, the use of leverage, fees, liquidity, your investment exposure, both on the upside and downside, to the credit worthiness of the issuer or other counter parties.

Hopefully it will help you better understand how structured products work and, perhaps more importantly, give you a road map for explaining them to your clients.

Features of Structured Products

Why they are important?

Underlying Asset

What is the asset that will determine the investment return and do you have a positive view on that asset? Is the asset simple or are there additional elements that have been incorporated that are not initially clear. (e.g. ASX20 – are you investing in the index or an equally weighted basket of the top 20 stocks?).

Capital at risk

Often investors only look at their initial capital outlay rather than cash flows over the whole term of the investment. As many structured products require ongoing payments with penalties being incurred if the investment is broken early, it’s important for you to look at all cash flows. Further, structured products often include the payment of fixed or variable income, effectively reducing the net payments and the total capital at risk. What is the total cash that you will have to pay out throughout the investment term should the investment performance not meet expectations?

Performance breakeven

The objective of the investment is to make a return on the invested capital- so how much does the underlying need to appreciate before the investment will become profitable?  Do you expect the underlying to be able to do this over the term of the investment? Are there any limitations to the upside such as a cap or is the underlying ‘volatility managed’ (discussed further below) and how could this impact potential returns?

Leverage

 

The objective of leverage is to assist you to obtain enhanced returns from your investment as a result of moves in the underlying asset. Leverage does also impact returns when the underlying is falling and you need to be comfortable that a fall in the underlying can produce material declines in the value of your investment.

Distributions

A distribution can reduce the carry cost of leverage, but may/may not affect the break-even of the investment. Does the product pay a distribution?  How often is a distribution made?

Credit worthiness of Issuer or other counterparties

 

Obligations of the Issuer and other counterparties to the investor need to be met. If any of these parties are of poor credit standing or there are not robust mechanisms in place to handle counterparty default, then you may be at risk of not receiving the return on the investment that you are otherwise entitled to. You also need to understand what happens in the event of Counterparty default.

Liquidity

 

Although most structured products are for a term longer than 12 months, some liquidity throughout the product life is important as your circumstances may change or you may seek to take profits prior to maturity. Does the investment offer liquidity and how often?  Are there any fees associated with early redemption?

Early Maturity

 

If an event occurs which causes an early maturity, you may miss out on further returns which could have resulted from remaining in the investment.  The circumstances surrounding early maturity need to be clearly understood, especially if there are any break costs or fees applicable.

Fees

Generally the fees paid out of a product to participants such as the Issuer, Arranger and Adviser will impact the economics for the investor.  Of course participants do need to get paid for their services, but excessive fee levels could negatively impact the potential returns available to you.  Also, fees may be charged for Early Maturity. You need to understand what fees are payable, and decide if they are reasonable.


Currency exposure

When obtaining exposure to offshore assets, currency exposure can impact the returns obtained by the investor.  This exposure may in some instances be completely removed by the structure of the product or, apply only to gains rather than the full notional exposure. You should ascertain if the investment has currency exposure and whether that exposure is on the notional exposure to the underlying, or limited to potential gains.

Downside exposure

Is the downside risk open-ended, or limited to a discrete amount of capital such as the Issue Price of the investment? This is an important risk management tool which can assist you to quantify the overall risk in a portfolio.

Capped upside

Is the return open-ended or limited to some pre-determined level? If it is capped, what maximum return does the investment provide?  Is the Issue Price of the capped investment sufficiently below the cost of an uncapped investment to justify the cap on upside?

Variable Participation Rate based upon volatility

 

Variable Participation Rate based upon volatility typically provides for exposure to the underlying of up to 150% when volatility is low.  This leverage feature can assist the product to outperform the underlying. Conversely, in times of high volatility when markets are often falling, it reduces the exposure to the underlying below 100% in order to once again seek outperformance over the underlying. You should ascertain what impact volatility management has had on historical returns of the investment.

Lock-in v ability to walk-away

As circumstances may change and markets may not perform as anticipated, it is important for you to have some flexibility in the potential term of your investment For leveraged products are you locked-in until maturity, or do you have the opportunity to walk-away and cease paying annual interest or other payments to the Issuer?

 

 

 

Important Note: The information on this website is provided for the use of licensed financial advisers only. The information is general advice and does not take into account any person's particular investment objectives, financial situation or investment needs. If you are an investor, you should consult your licensed adviser before acting on any information contained in this website.

Investors only: The information in this Document is confidential it must not be reproduced, distributed or disclosed to any other person unless it is part of their statement of advice. The information may be based on assumptions or market conditions and may change without notice. This may impact the accuracy of the information. In no circumstances is the information in this Document to be used by, or presented to, a person for the purposes of making a decision about a financial product or class of products.

General advice warning: The information contained in this Document is general information only. It has been prepared without taking account any potential investors’ financial situation, objectives or needs and the appropriateness of this information needs to be considered in that context. No responsibility or liability is accepted by Instreet or any third party who has contributed to this Document for any of the information contained herein or for any action taken by you or any of your officers, employees, agents or associates.

Past performance: Past performance is not a reliable indicator of future performance.