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You may have seen or heard structured products being offered by banks, institutions and financial advisers but what are they? Structured products are designed to offer highly customized risk-return objectives. This is accomplished by taking a traditional security, such as a conventional investment-grade bond, an individual share or index and replacing the usual payment features (e.g. periodic coupons, dividends and/or capital growth) with non-traditional payoffs that come from the performance of one or more underlying assets.

The payoffs from these performance outcomes are linked to the performance of the underlying assets in the sense that if the underlying assets return (x) then the structured product pays out (y). Structured products may contain underlying investments such as options, swaps, forward contracts and futures linked to assets as well as embedded features such as leveraged upside participation, limited downside risk or capital protection.

Structured products originally became popular in Europe but are now popular among private investors worldwide. Their ability to offer customized exposure, including to otherwise hard-to-reach asset classes and subclasses, makes structured products useful as a complement to other more traditional components of diversified portfolios.

Most structured notes are a package consisting of two or more components-usually a zero-coupon bond and a call option on one or more underlying equity instruments, such as a common stock or perhaps an ETF mimicking a popular stock index like the S&P 500. They will have a time frame for the investment usually between 1-5 years although many offer an early call option if certain conditions are met.

One common risk associated with structured products is a relative lack of liquidity due to the highly customized nature of the investment. Moreover, the full extent of returns from the complex performance features is often not realized until maturity. While there is a secondary market for notes to be bought and sold, structured products tend to be more of a buy-and-hold investment decision rather than a means of getting in and out of a position with speed and efficiency.

As an example we recently offered a note for clients in Europe backed by Deutsche Bank that provided annual returns of 12.9% per annum (in EUR), with 85% capital protection, an early call option and a 5 year term based upon European and UK stocks. This kind of note is typical of the structured notes available.

While structured notes can be an excellent way of improving returns or generating income I would always caution clients not to hold more than 20% of liquid investments in structured notes. Due to their longer term nature and relative lack of liquidity comparative to other investments available 20% is a fair holding with a maximum of 10% invested in any one note. When looking at structured notes you should always be wary of the issuer. I generally only buy structured notes for clients where the issuer is a large institution such as a bank with a good quality credit score.

The complexity of derivative securities has long kept them out of meaningful representation in traditional retail (and many institutional) investment portfolios. Structured products can bring many of the benefits of derivatives to investors who otherwise would not have access to them. As a complement to more traditional investment vehicles, structured products have a useful role to play in modern portfolio management. They can be tailor made to you specific requirements and offer easy access to markets or sectors that can be difficult to get into. Due to the complex nature of structured products and their use of derivatives it’s always worth discussing your needs with a professional, qualified and regulated adviser where appropriate.