“Structured products” is a rather generic phrase used in financial markets to describe a type of long-term note aimed at retail investors and based on one or more underlying assets. The investor pays for the product up front. Typically, if the underlying asset(s) perform moderately or better, the investor gets a decent return. If the underlying asset(s) perform moderately poorly, then the investor gets their initial investment back but no more. If the underlying asset(s) performs very poorly, then the investor loses money.
A classic “worst of two autocall” might work as follows: the product has a maximum life of six years. The underlying indices are the FTSE 100 and the Nikkei 225. The investor pays £100for the note. The initial levels of the FTSE 100 and the Nikkei 225 are noted.
Structured products come in all shapes and sizes. The above is just a single example. Some have “decreasing barriers” i.e. the price levels of the annual checks on the indices fall over time. Some pay an income during their life. Some have individual share prices, fx rates, interest rates or commodity prices as underlying assets. Others accrue income whilst the underlying assets are within a pre-specified range. There is an infinite variety.
This all appears to be pretty good. Why do they work? Well, the most important thing to note is that an investment in a structured product has a limited upside – it is capped out at the specified return – with a potential downside of losing all their money. Most investors want to make the opposite type of investment – limited downside and unlimited upside – and this is mainly what banks sell to clients. Selling a structured product suits a bank really well. It allows the bank to offset its regular risk(i.e. “hedge” the risk). Investors are selling insurance to banks in case the asset(s) significantly fall.
What decides on the level of return, and subsequent value, of a structured product?
- Market levels. The vast majority of structured products will do well when markets increase, so the lower the initial values the better.
- Volatility. This is a term used by the market to measure the uncertainty over asset prices. High volatility means high levels of uncertainty – people are worried. Low volatility means low levels of uncertainty – people are comfortable. Higher uncertainty means insurance costs more i.e. return levels for new structured products increase, values of existing structured products decrease.
- Credit risk. The investor in a structured product is effectively lending their money to the bank issuing the product. The worse the bank, the higher return the investor should get. Ironically, the most attractive structured products will come from poorly rated banks.
- Dividends. High dividends make share prices fall – as companies are paying out cash and therefore are worth less. To a regular investor, this doesn’t matter – they either make money from the share price or the dividends. But investors in structured products don’t receive the benefits of dividends, and hence an increase in dividends will hurt existing structured product values.
Given all this, how should structured products perform? It obviously depends on the specific design of the product, but very generally structure products will:
- Underperform markets in strong markets.
- Outperform markets in flat, weakly up and weakly down markets.
- Match market performance in very bad markets
Structured products can play an important part in an investor’s portfolio. They offer a decent return in the event of flat, meandering markets, when it is hard to make a good return from other assets. But the key to investing in them is timing entry. Buying a structured product when markets are high and volatility is low means locking in a potentially poor return and reducing the chances of even getting that return. To paraphrase business magnate Warren Buffet, “be brave when others are scared, and scared when others are brave”.
At Method, we believe the right time to enter into structured product investments is when markets are in relative turmoil – locking in lower initial levels and higher volatility. Our approach is to get clients in a position where they are ready to act, and then wait for the right conditions. Patience is key.