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Structured investment products (SIPs) may look like an excellent investment opportunity, with tailored terms, predetermined maturity dates, built-in capital protection and reliable returns.
Downside protection is an important feature which mitigates many of the risks and loss exposures inherent in other investment products and ensures your portfolio is safeguarded, to an extent, against negative market movements.
The issue may be that SIPS are created by investment banks for institutional investors and are not traded on open markets with the same accessibility as other products. There is also a significant credit risk, depending on the product terms, where if the issuing bank defaults, investors stand to lose everything.
The collapse of Lehman Brothers is a real-world example, creating multi-billion pound losses and triggering a financial crisis when the fourth-largest investment bank in the US filed for bankruptcy.
Table of contents
- How Do Structured Investment Products Work?
- The Benefits Of Structured Investment Products
- The Potential Downsides Of SIPs
- Are Structured Investments Right For You FAQ
- Related Articles, Guides and Insights
- Questions or Comments?
How Do Structured Investment Products Work?
SIPs, or structured notes, combine features, tracking underlying assets such as a stock, an index, currencies, equities, interest rates and commodities – most structured notes are based on a basket of linked assets.
Investors might have a structured note based on the performance of a well-known index such as the FTSE 100 or S&P 500 or could create a bespoke asset mix depending on their market knowledge and preferences.
These investment products also have a derivative element, so they act like a bond over a fixed period, normally three to five years, with a derivative such as an options contract built into the terms. This structure acts as a debt obligation the issuing bank owes at a pre-agreed maturity date.
The idea is to benefit from forecast market movements or asset appreciation while protecting investors from losses if values move unfavourably.
However, as with any investment, there are risks, and structured notes can be complex products designed for institutional investors with significant resources, market knowledge and capital. Even the most robust downside protection is not infallible.
The Benefits Of Structured Investment Products
SIPs are often used as a diversification product, balancing out other higher-risk aspects of an investment portfolio or investing in various asset classes, sectors, or markets to cushion the potential losses associated with alternative investments.
There is a need to be cautious of over-diversification, where adding additional products to an already well-balanced portfolio can increase the overall risk or negatively impact annualised returns.
Investors should also carefully consider the nature of the baseline index or basket of assets to ensure a SIP meets diversification objectives. If the structured note refers to assets or sectors that correlate with pre-existing investments, it may not be worthwhile.
Varied asset exposure
The hybrid nature of a structured note means that investors can peg their product to diverse assets, from index performance to commodities, and use their investment to gain exposure to multiple parts of the market.
Issuing banks can provide access to less widely accessible asset classes, including those rarely open to retail investors – although institutional investors more commonly use SIPs. This advantage is becoming less relevant as other, potentially lower-risk products provide the same accessibility.
Examples include exchange-traded funds (ETFs), mutual funds and exchange-traded notes (ETNs), all of which are similar ways to invest in non-standard assets and possibly easier to understand and monitor, given the complexity of SIPs and the derivative element.
Interested in funds? Please read our guide about how to invest in funds.
The most significant advantage of SIPs is the customisation of the product terms, risk exposure, capital protection and payouts, with some issuers creating structured notes with minimal risk. As always, the risk vs reward factor remains important, and higher-yield returns or more flexible price ranges normally have reduced or no capital protection.
SIPs can be created with income generation, downside protection, or growth as a priority. Income notes provide fixed-income coupons similar to a bond, whereas growth notes can combine coupons and upside returns like a stock investment.
However, this variable, customised structure also means the risks and considerations are unique to every SIP.
Derivatives allow investors to use SIPs in almost any economic environment, which can be desirable for those with sufficient knowledge of the markets. Likewise, leverage means that investors can achieve higher returns than the price appreciation of the linked asset but should be used with caution.
Investors can construct complex, diversified, and hedged SIPs to enhance their portfolio in less time, using a structured note in place of multiple separate portfolio elements, which would require extensive time and knowledge.
The Potential Downsides Of SIPs
One of the primary risks of SIPs is related to credit because any payout or coupon relies on the issuer’s credit standing and ability to fulfil the payout terms on maturity. As with the Lehman Brothers example, even the largest investment banks can be susceptible to overconfidence and excessive risk.
If the issuing bank forfeits or becomes financially risky, it may be impossible to exit any investment product or secure the contractual payout.
A SIP issued by a defaulting issuer might still be deemed favourable depending on the derivatives included. Still, the product’s value is more likely to be nil, which adds credit risk to the existing market risk.
Other investment products engaging directly in the market have only market risk to consider, and the investment bank’s reputation does not necessarily mitigate that exposure.
SIPs and liquidity
Structured notes are predominantly illiquid. There is little recourse to exit the product early and no secondary market where an investor could sell or trade a SIP – their only potential solution could be to sell the product back to the issuer.
However, an issuing bank would only offer a buy-back if the product had become more favourable and would not have any vested interest in protecting an investor from a sudden market movement or financial crash.
Even if the issuing bank were to agree to buy back the product, the price offered would rarely be viable.
SIPs and pricing
Once a SIP is issued, it is normally no longer tradable, and the pricing associated with these products is often inaccurate. Issuing banks use a pricing matrix rather than basing product pricing on net asset values, which is equivalent to an educated guess – and is at the issuer’s discretion.
Most SIPs are overpriced because the issuing bank will account for selling, hedging, and structuring costs, all of which are passed onto the investor.
The fees associated with structured notes are also higher than for ETFs, bonds, or stocks because the customised nature of the product means that issuers can charge more and need to contribute more time to creating and maintaining the product structure.
SIPs and call risk
Some SIPs have early redemption clauses, which normally mean the investor can be required to sell the product back to the issuer at a heavily discounted price against face value. Investors need to factor in the risk that the issuing bank redeems the note and exercises this option.
Are Structured Investments Right For You FAQ
Below are the answers to some of the more popular questions about Structured Products
The right investment products depend heavily on your capital, risk exposure appetite, market knowledge and experience. Structured notes are complex and are typically used by institutional investors to diversify a larger portfolio – they may not always be suited to retail investors or those newer to the markets.
Risk vs reward ratios are heavily varied and can be poor compared to conventional or direct investments with a clearer risk profile.
Issuing banks produce profiles and examples to demonstrate the upside potential and downside protection. These marketing materials may not illustrate the possible disadvantages and limitations enough to provide less experienced investors with sufficient information to make informed decisions.
There are several risks, but the default or credit risk is higher than a direct investment in debt or derivatives. The value of the product and redemption of coupons and capital depends on the financial liquidity of the issuer, so if they default, the entire investment is exposed.
Because SIPs are not traded on any established market, investors have minimal onward sale options if they wish to exit the product or sell the security before they reach maturity.
There are multiple investment products with higher liquidity. Investors can sell, buy, or trade quickly, which can be a distinct advantage in the event of changes to market forecasts and investor objectives.
The credit risk linked to structured products is significant. The credit quality and financial standing of the issuer are paramount – if the counterparty or issuer defaults or markets experience adverse price movements, there is a high risk of loss.
Structured products are unsecured debt obligations, and the creditworthiness of the issuing bank will impact its likelihood of repaying invested capital and meeting interest obligations.
No, investment products are not covered by the Financial Services Compensation Scheme (FSCS) in the UK or equivalent consumer insurer schemes in other countries.
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