Browse Analysis of Managed and Structured Products

23.1 Introduction

Learn about the features, advantages, and evolution of structured products in investment, as well as their role in providing unique risk, return, tax, and diversification benefits.

Introduction

Structured products provide investors with risk, return, tax, and diversification characteristics not available from conventional investments. The pricing of these products can reference a single security, a basket of securities, an index, commodities, or a combination of assets. They can be designed to provide enhanced yield, capital protection, and tax efficiency—alone or in combination.

Structured products were created as an alternative financing method with better terms than those of more conventional products used to raise business capital. These products are not currently subject to National Instrument 81-102, the regulation that governs many aspects of mutual funds. Unlike mutual funds, therefore, they can improve returns by using strategies such as leverage or derivatives.

The first structured products were designed to provide returns referenced to well-known securities, indexes, or investments (e.g., S&P 500 Equity Index or the price of gold bullion). These reference securities are called underlying assets. Over time, the underlying assets of structured products have become more varied to attract capital. As investor interest in the advantages of structured products has grown, so has their availability. Their ability to meet the unique needs of a more and more sophisticated investor market has undoubtedly been one of the factors that has contributed to the success of the structured product market.

Key Features of Structured Products

Risk Management

Structured products allow investors to manage risk by providing downside protection. For example, products can be engineered to offer principal protection by safeguarding the initial investment during periods of market volatility or decline.

Enhanced Yield

By employing strategies such as leverage or by linking returns to higher-performing assets, structured products can offer yields that surpass those of conventional fixed-income securities.

Tax Efficiency

These products can be designed to provide tax benefits, such as deferral of capital gains taxes, thus enhancing after-tax returns.

Diversification

Investors gain exposure to various asset classes and markets through structured products, promoting a diversified investment portfolio that can reduce overall risk.

Customization

Structured products offer flexibility in design, allowing them to be customized to meet the specific needs and risk appetites of different investors.

Strategic Components

  1. Leverage: Enhances returns but increases risk.
  2. Derivatives: Options, futures, and swaps to tailor risk/return profile.
  3. Underlying Assets: Determines the payout and profile of the structured product.

Evolution of Structured Products

Over the years, structured products have evolved to include a diverse range of underlying assets. Innovations in this market segment are driven by the demand for customized investment solutions. Popular underlying assets now include:

  • Equity indexes (e.g., S&P 500, NASDAQ)
  • Commodities (e.g., precious metals, oil)
  • Foreign currencies
  • Interest rates
  • Multi-asset combinations

Glossary

  • Structured Product: A pre-packaged investment strategy based on derivatives and a specific underlying asset.
  • Underlying Asset: The financial asset (e.g., stock, index, commodity) upon which a structured product’s performance is based.
  • National Instrument 81-102: Regulations governing mutual funds in Canada.
  • Leverage: Use of borrowed capital (margin) to increase the potential return of an investment.
  • Derivatives: Financial instruments whose value is derived from the value of an underlying asset.

Frequently Asked Questions (FAQs)

What are structured products?

Structured products are investment instruments designed to provide customized risk, return, tax, and diversification benefits that are not available through conventional investments.

How do structured products manage risk?

They offer features like principal protection, which ensures that the initial investment is safeguarded during market volatility or decline.

What are some examples of underlying assets?

Examples of underlying assets include equity indexes like the S&P 500, commodities such as gold, foreign currencies, and interest rates.

Are structured products regulated?

Structured products are not subject to National Instrument 81-102, the regulation that governs many aspects of mutual funds. This allows for the use of leverage and derivatives to enhance returns.

Can structured products be customized?

Yes, they offer flexibility in design, allowing them to be tailored to meet the specific needs and risk appetites of different investors.

Key Takeaways

  • Structured products offer unique benefits in terms of risk, return, tax efficiency, and diversification that are not available from conventional investments.
  • They can include a wide variety of underlying assets including equities, commodities, and interest rates.
  • The flexibility and customization of structured products cater to the increasingly sophisticated demands of investors.
  • Structured products are not subject to the same regulations as mutual funds, allowing for innovative financial strategies.
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## What do structured products offer that conventional investments do not? - [ ] Higher trading volumes - [x] Unique risk, return, tax, and diversification characteristics - [ ] Guaranteed returns - [ ] Daily liquidity > **Explanation:** Structured products provide investors with unique risk, return, tax, and diversification characteristics that are not available from conventional investments. ## What can the pricing of structured products reference? - [ ] Only a single security - [ ] Only an index - [x] A single security, a basket of securities, an index, commodities, or a combination of assets - [ ] Only commodities > **Explanation:** The pricing of structured products can reference a single security, a basket of securities, an index, commodities, or a combination of assets. ## What was the original purpose of structured products? - [ ] To provide guaranteed returns - [ ] To eliminate transaction costs - [x] As an alternative financing method with better terms than conventional products - [ ] To provide daily liquidity > **Explanation:** Structured products were created as an alternative financing method with better terms than those of more conventional products used to raise business capital. ## What regulation are structured products currently not subject to? - [ ] National Instrument 31-102 - [ ] National Instrument 81-106 - [ ] National Instrument 45-106 - [x] National Instrument 81-102 > **Explanation:** Structured products are not currently subject to National Instrument 81-102, which governs many aspects of mutual funds. ## How do structured products differ from mutual funds in terms of strategies? - [ ] They avoid dividend reinvestment plans - [x] They can use strategies such as leverage or derivatives to improve returns - [ ] They always provide capital protection - [ ] They can only invest in government bonds > **Explanation:** Unlike mutual funds, structured products can improve returns by using strategies such as leverage or derivatives. ## What are the underlying assets of structured products often based on? - [ ] Private equity - [x] Well-known securities, indexes, or investments like the S&P 500 Equity Index or the price of gold bullion - [ ] Small-cap stocks - [ ] Real estate > **Explanation:** The first structured products were designed to provide returns referenced to well-known securities, indexes, or investments like the S&P 500 Equity Index or the price of gold bullion. ## What are the reference securities in structured products called? - [ ] Equity bases - [ ] Commodity indicators - [ ] Derivatives - [x] Underlying assets > **Explanation:** Reference securities in structured products are called underlying assets. ## How has the availability of structured products changed over time? - [ ] It has decreased due to regulatory restrictions - [x] It has increased to meet the growing investor interest and needs - [ ] It remained constant - [ ] It shifted solely towards commodities > **Explanation:** As investor interest in the advantages of structured products has grown, so has their availability. ## Which factor has contributed to the success of the structured product market? - [ ] Guaranteed minimum returns - [ ] Daily liquidity - [x] Their ability to meet the unique needs of a sophisticated investor market - [ ] Exclusive focus on commodity markets > **Explanation:** The ability of structured products to meet the unique needs of a more sophisticated investor market has contributed to the success of the structured product market. ## What characteristic of mutual funds limits their ability to use leverage or derivatives compared to structured products? - [ ] Mutual funds focus only on ethical investing - [x] Mutual funds are governed by National Instrument 81-102 - [ ] Mutual funds only invest in fixed income securities - [ ] Mutual funds have unlimited diversification > **Explanation:** Mutual funds are governed by National Instrument 81-102, which restricts the use of leverage and derivatives, unlike structured products.

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Saturday, July 13, 2024