Structured retail products promise a return tied to a portfolio's earnings and guarantee you'll get your original investment back - regardless of what happens to the market! And some even offer to pay double or triple an index's return.

SEE: Basic Financial Concepts

You might wonder whether there's a catch. Can there really be reward without risk? It would seem so - that is, until you look beneath the surface. (To read more about too good to be true investments, see our Online Investment Scams Tutorial and How does a pump and dump scam work?)

The Products Investments
The financial institutions issuing structured retail products might invest in one or more stock indexes. For instance, these could include the DJIA, the S&P MidCap 400 Index, the S&P SmallCap 600 Index, the Dow Jones EURO STOXX 50 Index, or the Nikkei 225 Index.

Some even offer products that are tied to a handful of stocks in one industry, such as the energy sector.

Who Sells Them?
Several banks and brokerage firms offer structured retail products, each with a unique acronym, but the concepts are basically the same: If the underlying index or stock in the portfolio does well, you'll get a piece of the return. On the other hand, if the market tanks, you're assured to get all of your money back. Plus, they might throw in a little interest.

How They Work
One bank, for example, has a $1,000 five-year note that pays at maturity the greater of two amounts:

  1. Your principal plus a 5% total return (0.98% annual), which comes out to: $1,050
  2. A piece of the underlying portfolio's or index's return. The payout includes dividends, but it's credited quarterly and your account is charged for any losses in the index.

At the end of each quarter, you'll get credit by calculating the:

Ending Level - Starting Level
Starting Level

Then, the level is reset for the following quarter. Your total return is the compounded value of the 20 (five years x four quarters) quarterly returns. (To learn more about compounded values, see Understanding The Time Value Of Money and Continuously Compound Interest.)

The most you can make with this particular bank's product is 7% per quarter. Compounded, that comes out to 31% a year - not too shabby. But what if the market doesn't go up every quarter during the year?

Here's a hypothetical example of what could happen to a $10,000 investment that is tied to a market index during a volatile year:

Quarter Index Return Credited to Account Account Value
First 20% 7% $10,700
Second -15% -15% $9,095
Third 10% 7% $9,732
Fourth -5% -5% $9,245
-- -- -- --
Annual Return 6.59% -- -7.55%

In this case, the market had a 6.59% gain for the year. However, because of the way the earnings were credited with this bank's structured retail product, you would have actually lost 7.55%!

You wouldn't have this problem, though, if the market stayed on a steady, upward course throughout the year, as shown in the following hypothetical example:

Quarter Index Return Credited to Account Account Value
First 1.6% 1.6% $10,160
Second 1.6% 1.6% $10,323
Third 1.6% 1.6% $10,488
Fourth 1.6% 1.6% $10,656
-- -- -- --
Annual Return 6.56% -- 6.56%

How Does the Issuer Protect Your Capital?
Since the financial institution promises to return your principal, it has to hedge against a drop in the underlying index.

As a hypothetical example, imagine you invest $1,000 in a three-year structured retail product that is linked to the DJIA. The institution might put $865 of your money into a three-year zero-coupon bond that is set to grow to $1,000 at maturity. Therefore, if the index drops in value, the institution has the money to meet its obligation to you.

Next, the institution uses the remaining $135 to buy call options on the DJIA. That way if the index rises, it'll get both the initial principal ($1,000) and profits related to the index's growth to share with you. But if the index falls, the call options will not be exercised and the investor will still have his initial $1,000.

Other Versions
There are products out there that have different payout caps, such as 90% of the S&P 500's return.

You might also run across structured retail products that offer to pay a return at maturity that is a multiple of their underlying market index's return. However, the gains might be subject to limits, such as no more than a 30% total gain over two years, so don't expect to make a killing. Furthermore, you might have to share in a portion of any decline in the index; therefore, you could get back less than your initial investment. (To read more about capital gains, see Capital Gains Tax Cuts For Middle Income Investors and A Long-Term Mindset Meets Dreaded Capital-Gains Tax.)

How They're Taxed
The tax rules for structured retail products are similar to those of zero-coupon bonds. Therefore, even though you don't actually receive the guaranteed interest each year, you'll pay annual tax on it at your ordinary tax rate (up to 35% federal). At maturity, if the account is up, you'll get another tax bill on the additional earnings.

The Risks
Structured retail products carry a few risks. Among them:

  • Neither the FDIC, nor any other government agency, guarantees the products, regardless of whether you bought them from your bank. They are unsecured obligations of the issuing financial institution. As a result, if the issuer goes down the tubes, your investment could, too.
  • Structured retail products are not redeemable prior to the maturity date. You can try to sell on the open market, but the price you get may be influenced by many factors, such as interest rates, volatility and the current level of the index. As a result, you might end up with a loss.
  • You won't receive any interest while you own the account.

The Bottom Line
Structured retail products are a little like certificates of deposit tied to stocks - you get some upside potential with a safety net in case the market takes a dive. Plus, whenever interest rates rise, the minimum promised returns might be an attractive alternative to traditional fixed-income investments, such as bonds.

Nevertheless, there are restrictions, so make sure you understand the prospectus before you invest. Otherwise, you could be horrified to suddenly discover that you own an investment that goes down in an up market, and that you may not be able to sell it without taking a loss.

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