A brief news search in your favorite online search engine for “structured products” returns a number of articles from several major financial news organizations’ websites decrying structured products as unfit for savvy investors. For investors interested in these highly customizable financial instruments, such blanket critiques are misleading and unhelpful in communicating genuine information about the risks and advantages of structured products. This posting will address several general attributes of structured products that have fallen under such criticism and defend these innovative products from critics who too frequently ignore their purpose and function.
Structured products are highly customizable financial products intended to cater to unique risk-reward objectives. These products feature a payment structure that pays a predetermined return based on the performance of an underlying asset. The most essential feature of the structured product is its customizability.
A common criticism of these products is that they are too complex to be regulated and therefore too complicated for prudent investors to become involved with. One particular critic goes so far as to suggest that structured products are to blame for the 2008 global financial crisis. Such critics appeal to investors’ common sense, warning readers not to invest in anything they do not understand.
Aside from the implicit assumption that investors considering structured products are not working alongside experienced financial advisors, these critics err by conflating customizability and variety with indecipherable complexity. While it is true that many governments have loose oversight of structured products, this does not mean that the products are complicated beyond the scope of due diligence. Any investor willing to sit down with his personal advisor and have a discussion can readily understand an entire array of structured product options.
Another common critique concerns returns relative to other asset categories. In place of structured products, equity investment or savings accounts are suggested as more lucrative alternatives. To illustrate this critique, consider a hypothetical structured product similar in structure to the type brought into consideration by critics. Suppose we have a product in which an investor pays 60,000 GBP in principal. After 3 years, if the FTSE 100 falls below its initial value, the investor receives his principal plus 5,000 GBP. If after 3 years, the DJIA rises at all, the investor receives a return of 23%. This standard product offers both principal protection and predetermined gains based on the performance of an equity index.
One critic from a reputable investment blog begins his criticism of a similar structured product by attacking the product’s role as a principal protector. The author accurately observes that several interest paying savings accounts via either government savings funds or private financial institutions provide for a greater returns especially when inflation is taken into account. An investor in a GBP savings account yielding 5% yearly will earn nearly 6,000 GBP more than the investor in our example structured product if the equity index finishes below its starting value. The structured product investor may likely witness negative real returns once inflation is taken into account if the FTSE index does not rise.
This elementary mathematical exercise would be enough to convince any investor of the foolishness of investing in structured products if only these products were intended to serve purely as principal guaranteeing devices. However, structured products are decidedly not savings accounts, CDs, short-term sovereign notes, or any other sort of ultra low risk-low return inflation hedge. Investors invest in structured products to produce return in excess of that which these low return instruments offer. If all goes well, 60,000 GBP turn into nearly 75,000. If the markets do not perform well, the investor is relatively well off even if he loses a percentage point or two due to inflation. In the proper context of risk relative to reward, the criticism launched from the perspective of principal protection quickly subsides.
Which side is up?
A second critique focuses not on the downside but on the upside. In the case of a bull market, critics dismiss structured products in favor of equities. Equities, they claim, are preferable to structured products because they pay dividends and do not impose a limit upon the amount of return an investor can receive during a period of market growth.
Regarding dividends, many structured products pay quarterly coupon payments based on the performance of the underlying asset. Depending on the equity, this amount may very well be greater than dividend payments. Moreover, equities do not offer the option of downside protection that structured products do.
The critics’ qualms about the presence of a ceiling on returns are easy to demonstrate on paper but somewhat difficult to imagine encountering in today’s economy. A 20% rise in a major western index over a three-year period may be possible but does not seem overly likely given the macroeconomic state of the world at present. Assuming for the sake of our critic that there is in fact a miraculous 28% three-year rise in the FTSE, there are nonetheless three points to be made in defense of structured products.
If we return to our example product, we notice that our investor has missed out on 5% additional return that he could have made had he been solely invested in equities.
Despite this unfortunate lesson in opportunity cost and hindsight, what would have happened if the presumably equally likely scenario in which the FTSE 100 gains 18% were to have occurred? In this instance, our investor does not miss out on a 5% gain but makes such a gain.
Taking this one step further, how does one price in the possibility of earning 23% on a market gain of merely 1%? Most investors would find this to be a highly lucrative feature. This brings us to our second point: a 28% loss leaves the structured product investor nominally with more money than he principally invested. As already noted this downside risk protection is not offered by equities. Thirdly, and most importantly, the critic focusing narrowly on marginal returns in a bull market does not put structured products in the proper context. Structured products belong in a well-diversified portfolio that will undoubtedly contain a generous share of equity investment.
A laser light, not a magnifying glass…
Generally, writers who dismiss structured products do so by looking at these products through a narrow lens. They will focus on principal protection and decry the structured product for not being a savings account. They will then turn their attention to potential payoff and recommend to their readers that they never touch structured products due to limitations on return. Critics must split these hybrid products in half in order to so hastily cast them out of any reader’s consideration. If the critic is confronted with this objection, he claims structured products are too complex to be understood and lay the seeds of financial calamity.
Readers should be aware of such half-hearted dismissals of these innovative, customizable products. There are plenty of reasons to question whether or not structured product investment is prudent based on risk, potential returns, and most importantly, individual investment objectives. Not one of these factors is too complicated to be understood by investors.