An Introduction to 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 investment class broadly known as structured products. Structured products offer retail investors easy access to derivatives. 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 as stocks, bonds, exchange traded funds (ETFs) and mutual funds. 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.
Looking Under the Hood
Consider the following simple example: A well-known bank issues structured products in the form of notes, each with a notional face value of $1,000. Each note is actually a package consisting of two components - a zero-coupon bond and a call option on an underlying equity instrument, such as a common stock or perhaps an ETF mimicking a popular stock index like the S&P 500. Maturity is in three years. Figure 1 represents what happens between issue and maturity date.
Although the pricing behind this is complex, the principle is fairly simple. On the issue date you pay the face amount of $1,000. This note is fully principal-protected, meaning that you will get your $1,000 back at maturity no matter what happens to the underlying asset. This is accomplished via the zero-coupon bond accreting from its original issue discount to face value.
For the performance component, the underlying asset, priced as a European call option, will have intrinsic value at maturity if its value on that date is higher than its value when issued. You earn that return on a one-for-one basis. If not, the option expires worthless and you get nothing in excess of your $1,000 return of principal.
In the example above, one of the key features is principal protection. In another instance, an investor may be willing to trade off some or all of this protection in favor of more attractive performance features. Consider another case. Here, an investor trades the principal protection feature for a combination of performance features.
If the return on the underlying asset (R asset) is positive - between zero and 7.5% - the investor will earn double the return (e.g. 15% if the asset returns 7.5%). If R asset is greater than 7.5%, the investor's return will be capped at 15%. If the asset's return is negative, the investor participates one-for-one on the downside (i.e. no negative leverage). There is no principal protection. Figure 2 shows the option payoff chart for this scenario.
This strategy would be consistent with a mildly bullish investor's view - one who expects positive but generally weak performance and is looking for an enhanced return above what he or she thinks the market will produce.
Over the Rainbow
One of the principle attractions of structured products for retail investors is the ability to customize a variety of assumptions into one instrument. For example, a rainbow note is one that offers exposure to more than one underlying asset. A lookback is another popular feature. In a lookback instrument, the value of the underlying asset is based not on its final value at expiration, but on an average of values taken over the note's term, for example monthly or quarterly. In the options world, this is also called an Asian option to distinguish it from the European or American option. Combining these types of features can provide attractive diversification properties.
A rainbow note could derive performance value from three relatively low-correlated assets; for example, the Russell 3000 Index of U.S. stocks, the MSCI Pacific ex-Japan index and the Dow-AIG commodity futures index. Attaching a lookback feature to this could further lower volatility by "smoothing" returns over time.