How do Structured Products Work?
The below image provides an example of a theoretical structured note. Consider a simple, three-year, S&P 500 index-linked structured note with 100% principal protection promising preservation of capital, 80% participation with the index and a capped return of 20%. The various return scenarios are depicted:
How to Analyze Them?
While our example was (hopefully) useful from a conceptual standpoint, it was very basic as compared to most structured products in the market. As features are added to the products, complexities mount making appropriate levels of due diligence more difficult. In response, the U.S. Securities and Exchange Commission issued a 2015 bulletin that plainly stated, “While structured notes may enable individual retail investors to participate in investment strategies that are not typically offered to them, these products can be very complex and have significant investment risks. Before investing in structured notes, you should understand how the notes work and carefully consider their risks.” Additional considerations are listed below.
Know the fees and other costs associated with the investment.
Know whether the product is appropriate for the intended investment objective.
What other investment choices are available to me? Are other products available that provide investment exposure to similar assets, indices or strategies? If so, how do the costs of these other products compare to those associated with the structured note?
Carefully consider what might be a suitable investment for you, and whether there are better alternatives to the structured note you are considering. For example, can I purchase some or all of the components of the structured note separately for a better price?
How long will my money be tied up?
Are potential returns limited?
What is the credit risk of the issuer of the structured note?
For more information, please visit: https://www.sec.gov/oiea/investor-alerts-bulletins/ib_structurednotes.html
What is the Role of Structured Products in a Diversified Portfolio?
While the capital preservation feature and the customization of structured products can make them attractive for potential investors, the complicated payoff profile, opaque expense structure, lack of liquidity, and associated credit risk decrease their usefulness within a broad portfolio context. Investors should also consider opportunity costs associated with forgone investments in their overall strategy. In sum, the time-tested qualities of remaining patient, keeping costs low and being well diversified are most likely to drive long-term investment success.