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Remember when the world of finance was a peaceful place with clear lines separating institutional and individual investors? Individual investors diversified portfolios by allocating weights to the three major asset classes: cash; bonds; and stocks. Institutional investors accessed additional levels of diversification, including passive and active equity strategies, geographic dispersion, private equity, real estate, commodities, and hedge funds. How times have changed!
Today, through financial engineering, individual investors can access products that, while sometimes complex, put them on an equal footing with their institutional brethren. One notable innovation is an investment class broadly referred to as structured products.
Structured products are pre-packaged investments that normally include assets linked to bonds plus one or more derivatives. They are generally tied to an index or basket of securities and are designed to facilitate highly customized risk-return objectives. This is accomplished by taking a traditional security such as a conventional investment-grade bond and combining that with derivative securities on one or more underlying assets. This fixed income plus derivative structure tempers the potential payoff but protects the principal investment.
Structured products normally pay out at maturity. The fixed-income component provides the return of principal, and the derivative piece generates the payoff. This means that structured products are closely related to options pricing models, either by direct exposure to over-the-counter options or byproducts such as swaps, forwards, and futures that have embedded features, including leveraged upside participation and/or downside buffers.
Typically, large financial institutions issue structured notes with a notional face value of $1,000. Basic notes consist of two components: a zero-coupon bond and a call option on an underlying equity instrument such as common stock or an ETF that mimics a popular index like the S&P 500. The maturity can range between three and five years.
Although the pricing mechanisms that drive these values are complex, the underlying principle is simple. On the issue date, you pay the face amount of $1,000. Your principal is either fully protected or set up to minimize downside risk.
In the principal-protected note, you will get your $1,000 back at maturity no matter what happens to the underlying asset. This is accomplished via the zero-coupon bond accreting from its original issue discount to face value.
For the performance component, the underlying asset is priced as a European call option and will have intrinsic value (the difference between the strike price of the call option and the current value of the underlying asset) at maturity if its value on that date is higher than its value when issued. If applicable, you earn that return on a one-for-one basis. If not, the option expires worthless, and you will get back your initial investment.
The key driver for structured products is the principal protection. The tradeoff is that you must be willing to forfeit some of the underlying asset’s upside potential.
Over time, the basic structured note has morphed into more complex iterations with greater customization. Some versions provide exposure to more than one underlying asset. For example, a note might derive its performance from a basket of uncorrelated assets such as the S&P 500 Index, the MSCI Pacific Ex-Japan Index, and the Dow-AIG Commodity Futures Index.
Another twist is the so-called “lookback” feature where the value of the underlying asset is based not on its final value at expiration but on an average of values taken over the note’s term. This may be monthly or quarterly. This structure can lower volatility by smoothing returns over time.
One common risk associated with structured products is a relative lack of liquidity that comes with the highly customized nature of the investment. Moreover, the full extent of returns from complex performance features is often not realized until maturity. For this reason, structured products tend to be more of a buy-and-hold investment rather than a means of getting in and out of a position with speed and efficiency.
A significant innovation to improve liquidity in certain types of structured products comes in the form of exchange-traded notes (ETNs), a product originally introduced by Barclays Bank in 2006.
These are structured to resemble ETFs, which are fungible instruments traded like a common stock on a securities exchange. However, ETNs are different from ETFs because they consist of a debt instrument with cash flows derived from the performance of an underlying asset. ETNs also provide an alternative to harder-to-access exposures such as commodity futures or implied volatility.
The complexity of derivative securities has long kept them out of meaningful representation in traditional retail and many institutional investment portfolios. Structured products can bring many derivative benefits to investors who otherwise would not have access to them.
As a complement to traditional investment vehicles, structured products have a useful role to play in modern portfolio management. But their use case is magnified when employed by professional money managers.
Richard Croft is Founder, Chief Investment Officer, and Portfolio Manager of R.N. Croft Financial Group Inc.
Disclaimers
Content © 2025 by R.N. Croft Financial Group Inc. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. Used with permission.
Commissions, trailing commissions, management fees and expenses all may be associated with fund investments. Please read the simplified prospectus before investing. Investment funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently, and past performance may not be repeated. The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
R N Croft Financial Group Inc. is a Licensed Discretionary Portfolio Management and Investment Fund Management company serving investors and investment professionals across Canada since 1993.
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