By Wealth Foundations

What are structured investment products?

With growth assets going through a prolonged period of sideways, yet volatile, movement, there has been increasing demand from the investment public for alternative sources of return. Enter the structured product – a security that offers an attractive payoff with seemingly little of the downside risks associated with “vanilla” growth assets.

According to the European Structured Investment Products Association, structured products fall into three categories – capital protection, yield enhancement and participation products. They pay investors a return based on the performance of an underlying asset (such as a share, index or commodity) and in accordance with some pre-set rules.

The complex payoffs included in most structured products make them difficult to understand. Some investors equate this complexity with higher expected returns, yet they are simply repackaged versions of portfolios that combine multiple securities to generate a certain type of payoff.

Structured investment products offer “no free lunch”

The risk payoff of any structured product can be replicated via a portfolio of underlying securities plus derivatives written on those securities.

For example, take a high yielding product that offers an investor a higher than average rate of return. In exchange for this higher return, the investor gives the issuer the option to repay them with shares in the underlying company. If the issuer company’s share price continues to rise, it will be more favourable to repay the investor via cash. However, if the issuer company’s share price falls by (say) 25%, then the issuer can opt to repay the investor with shares, meaning the investor receives only 75% of their capital.

In effect, the investor is receiving two payoffs with this product – the average rate of return for the corporate bond plus a reward for giving the company the option to repay in either cash or shares. Most investors assume the option reward is free upside but overlook the associated cost.

Yet, we need to remember that the product issuer is the expert in this arrangement and the product is designed to allow them to raise capital and also purchase a cheap put option over their shares. The investor in this case is the unwitting seller of the cheap option.

There is no free lunch or any magic for investors when offered above average returns for less than (perceived) average risk. In most cases, they end up with below average returns for above average risk.

Most structured products offer inefficient risk/return payoffs that can be replicated more cheaply through alternative means. They also carry the disadvantages of liquidity risk, tax risk and issuer risk (as those who purchased Lehman Brothers structured products discovered). But worse, investors that purchase these products are playing a zero sum game with a seller that has a significant competitive advantage.

But what if we eliminated the provider and replicated these payoffs directly – would it then be worth including them in an investment strategy?

The payoffs offered by structured products require the investor to give up something (in the form of a lower return and/or limited upside potential) in exchange for something else (such as higher yield and/or downside protection). Unless an investor wants a payoff structure for a specific reason (such as to offset a pre-existing risk), they’re generally better off avoiding it.

For example, an employee with an over exposure to employer shares and an inability to sell them for 12 months may find appeal in a structure that protects their downside. A payoff structure that provides 12 months downside protection on the shares in exchange for giving up some of the upside return could enhance their position.

However, once the shares become available to sell, it would be foolhardy to retain them and enter another 12 month arrangement to forego upside potential for downside risk protection. It would be far more effective to simply sell the excess shares.

Structured investment products are a lottery

Lotteries offer a payoff similar to structured investment products. They offer the opportunity to invest a small sum ($1) in exchange for the (very small) chance to win a large sum ($ millions). Limited downside with massive upside – an enticing combination.

If they really offered such a good deal, we should start taking more of these risks and end up at the point where we’re prepared to invest our life savings in lottery tickets. In practice, no one does this because we know that the money’s made by being the lottery provider, not the purchaser. Somehow, this disadvantage tends to elude us when we purchase each individual ticket.

The same logic can be applied to structured products. If they offer such a good payoff, we should be prepared to accept them as a cornerstone of an investment policy and roll perpetually from one expired product to its replacement. Unfortunately, if you applied this approach, you’d end up losing a lot of money due to the inefficient nature of these offerings.

Investors are generally happy to give up upside potential for downside protection in the short term. But imagine continuing to take this sort of risk over a 20-30 year period. The cost of protection would eat away at your long term return and you’d end up far worse off than an investor who was prepared to accept the ups and downs of the market.

Interestingly, lottery ticket sales increase during tough economic times. Similarly, it seems, investors are resorting to the lottery of structured investment products to overcome their impatience with this phase of the economic cycle.

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Wealth Foundations (ABN 36 121 535 993) is a licensed Australian financial services firm (AFS Licence No. 317369). The material contained in this article is for general purposes only and should not be used as a substitute for personal financial advice. This article does not take into account your specific objectives, financial situation or needs. No person should act or refrain from acting solely on the basis of this material. Before making a financial planning or investment decision, you should consider if it is appropriate for your circumstances. You should read and understand any relevant Product Disclosure Statements or any other associated documentation relevant to your individual situation.