Once upon a time, the retail investment world was a quiet, rather pleasant place where a small, distinguished cadre of trustees and asset managers devised prudent portfolios for their well-heeled clients within a narrowly defined range of high-quality debt and equity instruments.

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Financial innovation and the rise of the investor class changed all that. One innovation that has gained traction as an addition to retail and institutional portfolios is the investment class broadly known as structured products. Structured products offer retail investors easy access to derivatives. This article provides an introduction to structured products with a particular focus on their applicability in diversified retail portfolios.

Structured products are designed to facilitate highly customized risk-return objectives.

Wiley: FX Options and Structured Products - Uwe Wystup

This is accomplished by taking a traditional security, such as a conventional investment-grade bond, and replacing the usual payment features e. The payoffs from these performance outcomes are contingent in the sense that if the underlying assets return "x," then the structured product pays out "y.

Structured products originally became popular in Europe and have gained currency in the U. Their ability to offer customized exposure to otherwise hard-to-reach asset classes and subclasses makes structured products useful as a complement to these other traditional components of diversified portfolios. Consider the following simple example: Maturity is in three years. Figure 1 represents what happens between issue and maturity date.

Although the pricing behind this is complex, the principle is fairly simple. This is accomplished via the zero-coupon bond accreting from its original issue discount to face value.

For the performance component, the underlying asset, priced as a European call option, will have intrinsic value at maturity if its value on that date is higher than its value when issued. You earn that return on a one-for-one basis. In the example above, one of the key features is principal protection. In another instance, an investor may be willing to trade off some or all of this protection in favor of more attractive performance features.

Here, an investor trades the principal protection feature for a combination of performance features. If the return on the underlying asset R asset is positive — between zero and 7. If R asset is greater than 7. If the asset's return is negative, the investor participates one-for-one on the downside i. There is no principal protection.

Figure 2 shows the option payoff chart for this scenario. This strategy would be consistent with the view of a mildly bullish investor — one who expects positive but generally weak performance and is looking for an enhanced return above what he or she thinks the market will produce.

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One of the principle attractions of structured products for retail investors is the ability to customize a variety of assumptions into one instrument.

For example, a rainbow note is one that offers exposure to more than one underlying asset. A lookback is another popular feature. In a lookback instrument, the value of the underlying asset is based not on its final value at expiration, but on an average of values taken over the note's term, for example monthly or quarterly.

In the options world, this is also called an Asian option to distinguish it from the European or American option. Combining these types of features can provide attractive diversification properties. A rainbow note could derive performance value from three relatively low-correlated assets; for example, the Russell Index of U.

Attaching a lookback feature to this could further lower volatility by "smoothing" returns over time. 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. Because of this, 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. A significant innovation to improve liquidity in certain types of structured products comes in the form of exchange-traded notes ETNs , a product originally introduced by Barclays Bank on June 12, These are structured to resemble ETFs, which are fungible instruments traded like regular common stock on a securities exchange.

ETNs are different from ETFs , however, as they consist of a debt instrument with cash flows derived from the performance of an underlying asset — in other words, a structured product. ETNs can provide access to hard-to-reach exposures, such as commodity futures and the Indian stock market.

In addition to liquidity, one risk associated with structured products is the issuer's credit quality. Although the cash flows are derived from other sources, the products themselves are legally considered to be the issuing financial institution's liabilities. They are typically not, for example, issued through bankruptcy-remote third-party vehicles in the way that asset-backed securities are.

The vast majority of structured products are from high investment-grade issuers only — mostly large global financial institutions such as Barclays, Deutsche Bank or J.

However, during a financial crisis , some structured products have the potential of losing principals to investors, similar to the risks involved with options.

For that matter, the U. Financial Industry Regulatory Authority FINRA suggests that firms "consider" whether purchasers of some or all structured products be required to go through a similar approval process, so that only accounts approved for options trading would also be approved for some or all structured products.

Another consideration is pricing transparency. There is no uniform standard for pricing, making it harder to compare the net-of-pricing attractiveness of alternative structured product offerings than it is, for instance, to compare the net expense ratios of different mutual funds or commissions among broker-dealers.

Many structured product issuers work the pricing into their option models so that there is no explicit fee or other expense to the investor. On the flip side, this means that the investor can't know for sure what the implicit costs are.

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. Dictionary Term Of The Day. A measure of what it costs an investment company to operate a mutual fund. Latest Videos PeerStreet Offers New Way to Bet on Housing New to Buying Bitcoin?

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Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. An Introduction to Structured Products By Katrina Lamb Updated January 30, — 6: What Are Structured Products? Looking Under the Hood Consider the following simple example: Figure 1 Although the pricing behind this is complex, the principle is fairly simple.

Custom Sizing In the example above, one of the key features is principal protection. Figure 2 This strategy would be consistent with the view of a mildly bullish investor — one who expects positive but generally weak performance and is looking for an enhanced return above what he or she thinks the market will produce.

Over the Rainbow One of the principle attractions of structured products for retail investors is the ability to customize a variety of assumptions into one instrument. Other Risks and Considerations In addition to liquidity, one risk associated with structured products is the issuer's credit quality. The Bottom Line The complexity of derivative securities has long kept them out of meaningful representation in traditional retail and many institutional investment portfolios.

High-net-worth investors find structured products appealing for a variety of reasons. Here's a look at four types. Structured notes are complex, high risk and might not be suitable for individual investors. At first glance, this product looks like the answer to investors' prayers.

In reality, it's just too good to be true. Spot a rotten investment before you get seduced by its sweet promise of profit. Learn how to use this type of investment as an alternative way to participate in the market. Different markets provide unique opportunities and risks for investors.

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