Browse Analysis of Managed and Structured Products

23.2.2 Advantages Of Structured Products

Learn about the advantages and features of structured products within the Canadian securities landscape. Understand their benefits, risks, and tax implications.

23.2.2 Advantages Of Structured Products

Advantages of Structured Products

Structured products have several significant advantages that make them appealing to investors. Here are key benefits:

Professional Management

Structured products benefit from professional management by experienced financial professionals who apply advanced strategies. This improves the chance of optimizing returns and minimizing risks.

Economies of Scale

Pools of structured products allow for cost efficiencies and shared expenses across a large number of investors, potentially leading to reduced costs per unit investment due to economies of scale.

Diversification

Combining various underlying assets mitigates risk. Structured products typically include a variety of high-risk and low-risk securities. This reduces exposure to any single asset’s volatility.

High Yields

At their given term-to-maturity, structured products often offer higher yields compared to conventional fixed-income instruments, despite their lower aggregate risk profile.

Principal Protection

At maturity, most structured products offer substantial assurance of principal protection, meaning investors are highly likely to receive their initial principal back.

Disadvantages of Structured Products

However, these financial instruments come with their downsides:

Complexity

Structured products can be complex, particularly those involving significant derivative use, making them hard for some investors to assess properly.

Illiquidity

Many structured products suffer from a thin or non-existent secondary market, making them difficult to liquidate prematurely.

Embedded Costs

Investors face extensive embedded fees including selling commissions, management fees, performance fees, structuring fees, trailer fees, and swap arrangement fees. These high fees can create significant hurdles to achieving acceptable returns.

Risks Involved With Structured Products

Structured products, like all investments, carry risks. Here are the ones specific to structured products:

Prepayment Risk

Certain structured product components might involve mortgages that can be paid off earlier than expected. Prepayments can shorten product life, potentially reducing investor returns.

Other General Investment Risks

  • Default Risk
  • Inflation and Interest Rate Risk
  • Currency Risk
  • Manager Risk

Principal-Protected Notes

Features, Risks, Benefits, and Tax Implications

Principal-Protected Notes (PPNs) are a type of debt instrument (( \mathbb{PPNs} )) that banks issue. They guarantee principal protection at maturity but have returns tied to an underlying asset’s performance.

Features

PPNs are tied generally to a portfolio of stocks, indices, mutual funds, or ETFs. They often use a Zero-Coupon Bond Plus Option Structure, investing primarily in zero-coupon bonds and using remaining funds to buy options on underlying assets.

Advantages

  • Principal guaranteed at maturity
  • Potential for higher interest rates due to underlying assets’ performance

Mermaid Chart of PPN Structure👇.

    pie
	title Zero-Coupon Bond Plus Option Structure
	"Zero-Coupon Bond": 80
	"Option on underlying asset": 20

Common Types of PPNs in Canada

Index-Linked PPNs with Participation Rate

  • Participation Rate: Limits payout based on a percentage of the index return.
  • Example Calculation: $$Jomal’s \ Return \ = 33% \times 0.75 \implies 25$$.

Index-Linked PPNs with Performance Cap

  • Performance Cap: Payout stops at a specified percentage; returns above cap are not earned.

Risks and Other Considerations

  • Liquidity Risk: No secondary market guarantee.
  • Performance Risk: Real returns may diverge significantly from underlying assets.
  • Credit Risk: CDIC does not cover these instruments; they rely on issuing banks’ creditworthiness.

Tax Implications of PPNs

  • Returns (interest) are taxed at marginal tax rates even if they predate maturity when PPNs are sold.

Market-Linked Guaranteed Investment Certificates (GICs)

Structure, Risks, and Tax Implications

Market-linked GICs offer principal protection and are linked to indexes, mutual funds, or ETFs.

Structure

  • Features a competitive growth+ principal guarantee.
  • They come in set terms, usually non-redeemable until maturity.

Calculation of Returns

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📚✨ Quiz Time! ✨📚

🧐 Assess and Solidify Your Understanding

Welcome to the Knowledge Checkpoint! You’ll find 10 carefully curated quizzes designed to reinforce the key concepts covered. These questions will help you gauge your grasp of the material, identify areas that need further review, and ensure you’re on the right track towards mastering the content for the Canadian Securities certification exams. Take your time, think critically, and use these quizzes as a tool to enhance your learning journey. 📘✨

Good luck! 🍀💪

## What is one of the main advantages of structured products in terms of risk? - [ ] They are always guaranteed to provide high returns. - [ ] They are very easy for investors to understand. - [ ] They are highly liquid with active secondary markets. - [x] They combine high-risk, illiquid securities into one lower-risk security. > **Explanation:** Structured products combine high-risk, illiquid securities into a single security that typically offers lower risk compared to the individual securities themselves, often resulting in higher yields for a given term-to-maturity. ## Which of the following is a disadvantage of structured products? - [ ] High liquidity in the secondary market - [ ] Simple to understand for most investors - [x] Complexity and difficulty in assessing inherent risks - [ ] Zero transaction fees > **Explanation:** Structured products are often complex and difficult for many investors to fully understand, especially those involving significant use of derivatives. ## What is a Principal-Protected Note (PPN)? - [ ] A type of equity instrument issued with a performance cap - [x] A debt instrument issued by banks that guarantees the return of principal at maturity - [ ] A fixed-income security similar to a Treasury bill - [ ] An investment vehicle that guarantees regular income payments > **Explanation:** A PPN is a debt instrument issued by banks that promises to return the principal amount of the investment at maturity, with any interest depending on the performance of an underlying asset. ## What is a common feature of an index-linked Principal-Protected Note with a participation rate? - [ ] Guarantees the same returns as the underlying index - [x] Limits the final payoff to a percentage of the return on the index - [ ] Always pays out dividends and distributions from the index constituents - [ ] Contracts shorter than three years > **Explanation:** An index-linked PPN with a participation rate limits the final payoff to a percentage of the return on the index—investors do not receive the full return of the index. ## What type of risk is unique to structured products like Mortgage-Backed Securities (MBS)? - [x] Prepayment risk - [ ] Credit risk - [ ] Inflation risk - [ ] Manager risk > **Explanation:** Structured products like MBS carry prepayment risk, where underlying mortgages may be paid off earlier than expected, potentially affecting the returns. ## Which entity is responsible for guaranteeing the principal return of a PPN in Canada? - [ ] Canada Deposit Insurance Corporation (CDIC) - [ ] Government of Canada - [x] One of the Big Six banks - [ ] Provincial government > **Explanation:** In Canada, the principal return of a PPN is guaranteed by the issuing entity, which is typically one of the Big Six banks. ## What does the 'performance cap' in a principal-protected note do? - [x] Limits the maximum return that the investor can earn - [ ] Ensures a minimum return for the investor - [ ] Provides a fixed rate of return regardless of market conditions - [ ] Caps the fees associated with the investment > **Explanation:** The performance cap limits the maximum return that the investor can earn from the structured product, so once the limit is reached, further growth does not affect the investor's return. ## What is an important tax implication of Principal-Protected Notes (PPNs)? - [ ] Returns are considered capital gains - [ ] Returns are tax-free if held until maturity - [x] Returns are generally taxed as interest income - [ ] Returns are eligible for a dividend tax credit > **Explanation:** Returns from PPNs are generally taxed as interest income, so the gains are added to the investor's income and taxed at their marginal tax rate. ## Why might investors find structured products challenging to understand? - [ ] Because of their high liquidity - [x] Due to the use of complex derivatives and fee structures - [ ] Because they are highly regulated - [ ] Due to their uniform nature and limited investment options > **Explanation:** Many investors find structured products difficult to understand because they often involve the use of complex derivatives and have various embedded fees. ## Which of the following is not a typical feature of Market-Linked Guaranteed Investment Certificates (GICs)? - [ ] Principal guarantee - [ ] Maximum cap on returns - [ ] Participation rate - [x] CDIC insurance > **Explanation:** Market-Linked GICs do not typically have insurance from the Canada Deposit Insurance Corporation (CDIC). Instead, they combine a principal guarantee with potential returns linked to an underlying asset.

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Saturday, July 13, 2024