Structured Products: You Can Have Your Cake and Eat It Too–Almost

This column is for the risk adverse among us, especially those who would like to be in the stock market but may be afraid of loosing your shirt (or blouse). An investment vehicle in the United States, called Structured Products, could be the right prescription for you.

Structured Products are pre-packaged investment products that come in many flavors ranging from the most complex to plain vanilla. These specialized notes allow you to bet on the upside in the stock markets by linking your note to an equity index (The Dow, S&P 500, NASDAQ, etc.) while protecting 100% of your investment or principal as long as you hold the note to maturity, usually 5-7 years. They have been popular in Europe for some time where a retail investor can pick one up at the post office or even the supermarket. In America, our largest financial institutions began to use them a few years back. Since then new issues of structured products have grown quickly into a $100 billion market this year. And now they are being offered to you and me for a fee.

There are lots of ways to design these products. Typically, a part of your investment purchases something traditional like a stock, bond or a basket of stocks called a market index. Then a portion of the money is set aside to buy what is called a derivative, things like options, warrants, swaps or futures to enhance your returns. What’s a derivative?

We use derivatives every time we buy home heating oil pre-season. We sign a contract with a local energy supplier for a specific period of time (this winter) at a certain price per gallon for a certain amount of fuel. We do this because we think the price of fuel could be higher in the winter so we “hedge” or protect ourselves from future price increases. Now let’s say you agree to pay a small amount monthly to your supplier for this privilege. This enables you to control a lot of fuel and protect yourself from price increases while paying only a fraction of the overall price. Your fuel contract will increase in value every time the price of gas or oil goes up versus someone without a contract who “takes their chances” that the winter will be mild.. All derivatives derive their value and price in the same way, from the value of the assets underlying them. The same kind of engineering occurs within a structured product. Derivatives provide leverage, protection and enhanced returns. They are the va-voom in your portfolio.

Structured products may be useful to more than just us nervous Nellie’s. This kind of investment might appeal to retirees or readers approaching retirement who can’t afford to lose a lot in the stock markets but need higher returns to bolster their savings. Maybe you’re looking to do a bit better than the rate on your CDs but can’t stomach market volatility or saving for a specific financial goal, like your child’s education, something you can’t afford to lose, especially if the market takes a precipitous dive over a protracted number of years.

How do they work? Let’s take a hypothetical example, a $10,000 IRA investment which I plan to let grow untouched for the next five years. For a fee, say 5% which would be equal to $500, an investment bank invests my ten grand and guarantees me 80% of what the S&P 500 stock index does over the next five years. So if the index is up 100%, I make 80% of that or $18,000. At the same time, if we have a market crash my principal is protected (hedged) completely and I walk away after the time period with my original $10,000 minus the fee.

So what’s the catch? First of all there is that fee. If the worst happens and the markets are down, my $10,000 minus the 5% fee equals $9,500. Second, because these products use a substantial amount of derivatives rather than direct investments in stocks or mutual funds you don’t get any dividends. Dividends are an important component of the overall market’s investment returns (like making a salary with no bonuses). Finally, if you need your investment back before the note matures, you may lose money if you sell it on the secondary market and/or you may have to pay additional fees or commissions or both.

It is probably best to talk to a financial advisor or planner about structured products because there is usually a minimum investment required and fees vary depending on the complexity of the product. However, given the roller coaster ride of world markets this summer, structured products may offer a way to have your cake and eat it too.