Structured products offer fixed future payout

December 1, 2010

A structured product is a contract that promises to pay a future amount based on the performance of an underlying asset, such as a stock, market index, or commodity. The payoff is usually linked to a preset formula.

Key Points

Q: My broker recommended that I invest in a "structured product." What are structured products, and what do I need to know about them?

Most structured products are designed to either preserve capital or enhance returns, and are typically issued as notes. The notes offer a specific payout over a designated time period or at maturity, and the final payout depends on the performance of the underlying asset as well as the value of the derivatives written on it. Since an investment bank typically issues the product, the investor is exposed to the credit risk of that entity.

These are a few of the common characteristics of structured products:

Complex design. Most products have a complex design, which can make analysis of pricing, risk exposure, and potential outcomes more difficult. Some investors equate this complexity with higher potential returns when, in fact, it may only mask high fees and risk. Worse yet, investors may not understand the range of possible outcomes. During the 2008 market crisis, some investors learned a hard lesson when the issuing firm went bankrupt or when their structured product experienced losses from poor performance of the underlying asset.

Substantial cost. These products tend to carry a significant markup and costs that in some cases are difficult to quantify, especially if an investor lacks the technical knowledge to analyze the underlying components of the strategy.

Tradeoffs. In return for receiving a prescribed payout, investors must accept a lower return and/or limited upside potential. To pursue higher expected returns, you must accept more risk. If you do not want to bear the necessary risk, you must transfer it to other investors and pay them for taking it.

Multiple risks. First, there are the inherent risks of the underlying security (ie, the stock or index). Investors also are exposed to credit risk of the issuing firm. The contract is an agreement with the issuer to make a predetermined payment in the future, and thus it is contingent on the firm being able to deliver.

Liquidity risk is another issue. Although many structured products are listed and traded on exchanges, they may be difficult to sell, especially in a volatile market. To avoid a potential liquidity problem, investors should consider the time horizon of the product and attempt to match its maturity to their anticipated financial need or objective.

A structured product might help an investor who needs a specific payout at a designated point in time and who is willing to pay another party to shoulder much of the uncertainty. Unfortunately, this benefit generally comes at the expense of lower yield or limited upside potential. Many investors may prefer investment alternatives that are less complex and more transparent for their diversification needs.

Q: Does it make sense to diversify by investing in emerging markets?

A: The emerging markets have been maturing based on an increase in overall macroeconomic stability. Most governments are implementing conservative fiscal policies as well as independent monetary policy. Large budget deficits and high inflation have been replaced by stable growth and price stability. Previously, U.S. dollar-based investors lost significant value due to adverse currency movements in the emerging markets. This risk has been decreased as the fundamentals of emerging market currencies have improved dramatically in recent years.

As part of an overall diversified portfolio, it can certainly make sense to have some level of exposure to the emerging markets. This can be accomplished by investing in publicly traded mutual funds, which offer diversification among many emerging market countries. In order to invest in one particular country, another option would be to utilize exchange-traded funds, which trade on the U.S stock markets.

Joel M. Blau, CFP, (top) is president and Ronald J. Paprocki, JD, CFP, CHBC, is chief executive officer of MEDIQUS Asset Advisors, Inc. in Chicago. They can be reached at 800-883-8555 or blau@mediqus.com
or paprocki@mediqus.com