An Explanation of Structured Investments
Given the popularity of structured investments (also called notes or products) in Europe and Japan, and their growing use in the U.S., we thought it would be important to explain them to our readers.
A structured product is not an investment class at all, it is simply a corporate obligation sponsored by a large financial institution, whose performance is tied to one or more market benchmarks (stock, index, currency, commodity, interest rate, etc.) Thus a structured investment is merely a tool or wrapper that enables unique investment outcomes, which are then paid by the issuer at maturity in the form of a return of the initial investment plus or minus the return on the underlying benchmark. Most structured products also carry some form of principal protection, either in the form of a full guarantee or through a buffer to insulate a portion of losses (often the first 10% of losses). This protection does not come cheaply, as the issuer will normally limit the potential gains on the product as compensation for the guarantee.
Structured investments are utilized to gain exposure to a given area of the market with a risk/reward profile that is unattainable through more ordinary investments. Although many investors employ structured products as a component of a long term investment program, their downside protection makes them very useful as a tool to time investments into a market when the risk of decline is perceived to be high. Also, they are a good way to gain access to an unfamiliar asset class which might otherwise expose the investor to large potential losses (currencies, commodities, interest rates, etc.). Finally, many issuers use them to offer clients access to sophisticated in-house trading strategies, many of which have limited track records and thus the downside protection is critical.
Structured investments are promoted heavily in Europe and are often positioned as a special proprietary product of the firm that only their clients are offered. In reality, the market for structured products is very large and efficient, and there are numerous open-architecture issuers in the marketplace with products that are far superior to those of the large brokerage houses, who mainly create them for their own captive audience.
Investors in Europe have long favored structured investments due mostly to the downside protection offered. European investment behaviors are considerably less risk tolerant than in the U.S., and Europeans allocate a much larger portion of their assets to safe investments such as cash, pensions, and insurance.
American investors have been slower to embrace structured notes due to the cultural acceptance of more typical stock market investing through mutual funds, and the accompanying market volatility. Additionally, the tax and regulatory environment in the U.S. has historically been unfavorable; although this is changing. The stock market retreat that began in the 4th quarter of 2007 has awoken the U.S. market to structured products and large issuers of these products have been quick to go on tour with the message of partial participation in the market with downside protection. Ultimately, structured investments may be a tough sell for the broader American market due to their expectation of full transparency into the true fees and costs of the product.
In summary, we believe that structured investments are a valuable tool which can be utilized to accomplish certain investor goals. However, many of these products are sold by appealing to investor's fear of losing money (similar to how annuities are often sold), and the true opportunity cost of the products is rarely explained. While we do not use them in most client portfolios, we do see the appeal of these products to accomplish specific client goals.
Source: Maxim Global Wealth Advisors, By Andrew Fisher, CFA, CPA – 2008
Investment Management
