Investing in an uncertain world \u2013 structured products demystified

In this world of political uncertainty, trade wars and rising US interest rates, many investors are looking for investments that can give them peace of mind. Structured products can fit the bill, providing capital protection and geared returns. However, the concepts and terminology can be daunting for investors, discouraging them from taking part in what should be a very useful tool in one’s portfolio.

In this article, we attempt to demystify the main features of structured products and explain the role they can play in a diversified portfolio.

Each equity structured product is different, but most share the following features that will determine returns:

They have some form of capital protection built in

This is arguably the most well-known feature of structured products.A typical structured product will have a maturity of between three and five years, with the initial capital either protected 100%, or with protection of losses up to a certain percentage (say 20% or 30%).

The returns are geared

This simply means that investors earn a multiple of the return of the reference index or group of indices. Returns are often capped at a certain level, but investors will still earn a multiple of the growth up to that cap. For example, the structure may give the investor two times the return of the underlying index, capped at 60%. So, if the index grows by 50% over five years, the investor will earn a 100% return. If the index grows by more than the 60% cap, the investor will earn 120% (the 60% times two). Only if the index returns more than 120% will the investor have been better off in the index itself. Such gearing is thus very useful for investors who are bearish or only mildly bullish about the underlying market.

They can provide returns in rand or foreign currency

Structured products will often link returns to a well-known stock market index, such as the S&P 500, FTSE 100 or Nikkei. Others will be linked to a group of indices. It’s important to look at the currency the returns are linked to. Some will offer the return in US dollars, euros or sterling, while for others, the returns will be in rand. Investors will choose which one they want, depending on how much rand or foreign currency exposure they want.

There are some non-market risk factors that investors should be aware of:

Credit risk

A structured product is essentially a contract between the investor and issuer, with the latter promising to deliver the returns described above. Investors take credit risk on the performance by the issuer of their obligations under this contract. In some cases, to enhance the returns payable to the investor, credit risk on a second entity may be introduced into the transaction via a credit reference. In these cases, the product payout is dependent on the performance of both the issuer and the credit reference entity.

Liquidity

Most structured products are designed to run over three to five years, so ideally investors should only invest money they’re prepared to put away over that length of time. However, circumstances can change, and investors will often need access to their cash due to unforeseen events. Many issuers will offer to help investors find a willing buyer of the structured product where the investor wants access to capital, or may offer to repurchase the instrument themselves.

In short, once one understands a few basic concepts, structured products need not be complex at all.

Brian McMillan, Head: Retail Sales, Investec Structured Products