What is a Structured Investment Products (SIPs)?

Structured investment products, or SIPs, are types of investments that meet specific investor needs with a customized product mix. SIPs typically include the use of derivatives. They are often created by investment banks for hedge funds, organizations, or the retail client mass market.

SIPs are distinct from a systematic investment plan (SIP), in which investors make regular and equal payments into a mutual fund, trading account, or retirement account in order to benefit from the long-term advantages of dollar-cost averaging.

Understanding Structured Investment Products (SIPs)

A structured investment can vary in its scope and complexity, often depending on the risk tolerance of the investor. SIPs typically involve exposure to fixed income markets and derivatives. A structured investment often starts with a traditional security, such as a conventional investment grade bond or a certificate of deposit (CD), and replaces the usual payment features (such as periodic coupons and final principal) with non-traditional payoffs, derived not from the issuer's own cash flow, but from the performance of one or more underlying assets.

A simple example of a structured product is a $1000 CD that expires in three years. It doesn't offer traditional interest payments, but instead, the yearly interest payment is based on the performance of the Nasdaq 100 stock index. If the index rises the investor earns a portion of the gain. If the index falls, the investor still receives their $1000 back after three years. This type of product is a combination of a fixed income CD a long-term call option on the Nasdaq 100 index.

The Securities and Exchange Commission (SEC) began scrutinizing structured notes in 2018, due to widespread criticism over their excessive fees and lack of transparency. As an example, in 2018, Wells Fargo Advisors LLC agreed to pay $4 million and return ill-gotten-gains to settle SEC charges after it was found that company representatives actively encouraged people to buy and sell one of their structured products which was supposed to be bought and held till maturity. This churning of trades created big commissions for the bank and reduced investor returns.

Key Takeaways

  • Structured products are created by investment banks and often combine two or more assets, and sometimes multiple asset classes, to create a product that pays out based on the performance of those underlying assets.
  • Structured products vary in complexity from simple to highly complex.
  • Fees are sometimes hidden in the payouts and fine print, which means an investor doesn't always know exactly how much they are paying for the product, and whether they could create it cheaper on their own.

SIPs and the Rainbow Note

Structured products attract some investors with their ability to customize exposure to different markets. For example, a rainbow note offers exposure to more than one underlying asset. A rainbow note might derive performance value from three relatively low-correlated assets, like the Russell 3000 Index of U.S. stocks, the MSCI Pacific Ex-Japan Index, and the Dow-AIG commodity futures index. In addition, attaching a lookback feature to this structured product could further lower volatility by "smoothing" returns over time.

In a lookback instrument, the value of the underlying asset is not based on its final value at expiration, but on an optimal value taken over the note's term (such as monthly or quarterly). In the options world, this also coincides with an Asian option (to distinguish the instrument from European or American options). Combining these types of features can provide even more attractive diversification properties.

This shows that structured products can range from the relatively simple CD example mentioned prior, to the more exotic version discussed here.

Pros and Cons

Advantages of SIPs include diversification beyond typical assets. Other benefits depend on the type of structured product, as each one is different. Those advantages may include, principal protection, low volatility, tax efficiency, larger returns than the underlying asset provides (leverage), or positive yields in low yield environments.

The disadvantages include complexity which can lead to unknown risks. Fees can be quite steep, but are often hidden within the payout structure or in the spread the bank charges to enter and exit positions. There is credit risk with the investment bank backing the SIPs. There is usually little or no liquidity for the SIPs, so investors must take the price the investment bank is quoting or may not be able to exit before maturity at all. And while these products may offer some diversification benefits, it isn't always clear why they are needed or under what circumstances they are needed other than to generate sales fees for the investment bank creating them.

Real World Example of Structured Investment Products (SIPs)

By way of example, assume that an investor agrees to put $100 into a structured product based on the performance of the S&P 500 stock index. The more the S&P 500 goes up, the more the structured product is worth. But if the S&P 500 goes down, the investor still gets their $100 back at maturity.

For this service, the bank takes several fees or generates revenue in a few different ways. It may cap how much the investor can make, and therefore anything the S&P 500 moves above that cap is the profit of the bank, not the investor. The bank may also charge a fee. This may not be apparent, but rather factored into the payouts. For example, the S&P 500 may need to rise 5% in year one in order for the client to receive a 2% payout. If the S&P 500 rises less than that, the payout decreases proportionality. The investor may receive nothing if the S&P 500 rises 3% or less, which is the bank's profit.

This product combines a CD or bond with a call option on the S&P 500 index. The bank can take the interest it would have paid and buy call options. This helps protect the initial capital while still providing upside profit potential if the stock index rises. The bank can also hedge any exposure it may generate on more complex structured products, which means they are typically not concerned about which way the market moves.