How to take more control over risks and returns

The past year’s market tumult and uncertainty since “Liberation Day” make stability especially desirable. When it comes to investors’ portfolios, there are tools available that seek to provide resilience. Structured products can be designed to help manage portfolio risks, potentially making it easier to stay invested longer-term when the environment may feel unpredictable.

Incorporating structured products can help construct a portfolio designed to better withstand market uncertainties. 

With today’s backdrop of inflation and interest rate changes, and macroeconomic uncertainty, structured products have emerged as versatile financial tools that may support investors in getting and staying invested with greater confidence.

Structured products: A quick review

Structured products are hybrid financial instruments created by pairing a fixed income instrument with an over-the-counter (OTC) derivative that can express a view on any asset class—equity, fixed income, commodity or currency. How does utilizing a structured note compare to owning the underlying asset outright? By allowing you to change the investment’s risk-reward profile, allowing more flexibility and customization to the investment.

Let’s break down the structured product. 

First, we start with the derivatives package. The derivative piece allows the purchaser to adjust the underlying asset’s risk and reward profile—the underlying asset’s performance largely determines the note’s value. In practice, investors often use structured products to trade away some potential upside in exchange for greater downside mitigation. 

Structured products can accomplish other goals, too, depending on investment objectives. The instruments can encompass mass market offerings or can be highly customizable.

Structured products may act as a way to create more defined payouts for a portion of an investor’s portfolio. They’re not necessarily an asset class, but they can complement traditional asset classes such as equities or fixed income. Structured products serve as a “third leg” in the portfolio stool—an “off-menu” approach for those seeking a so-called “asymmetric payoff,” meaning the potential for gain is greater than the potential for loss—the upside potential is greater than the downside risk.

Investors can consider shifting a portion of existing equity or fixed income exposure to structured products, building out a hybrid allocation in their overall portfolios. Or investors can fund structured products from excess cash.

Structured products are also subject to market risk.

Let’s examine how and when structured products might be advantageous. 

Why consider structured products?

While it’s common to think of structured products as tactical tools only useful during market drawdowns or amid elevated volatility, they can do more because they’re highly customizable, with a range of risk-return profiles suitable for various investing goals and market environments.

Inflation, interest rate risk, political uncertainty and a potential AI bubble remain top concerns for investors today. In this environment, structured products can potentially provide:

• Potential for tailored risk-return profiles. Historical data shows that structured products can provide outcomes with reduced volatility—returns are tied to the performance of the underlying security, but can be designed to give up some upside in exchange for limiting downside.
• The possibility of amplified market returns. Structured products can be an attractive opportunity in an uncertain environment. Our analysis found a fixed income structured product’s asymmetric risk-return is historically in line with a traditional balanced portfolio, with a modest increase in risk.
• The ability to define your risk parameters. Structured products paired with an investor’s portfolio might be designed to, for example, mitigate duration risk (i.e., a bond’s sensitivity to a change in interest rates). Today’s expected declining rates should help bond prices, but there are still duration risks, even now. Using structured notes can help you choose a point at which you’re comfortable selling away upside for downside mitigation. 
• A prepackaged approach. While investors can execute in the listed options market , some find the complexity intimidating. Structured products offer an all-in-one package that encompasses exotic options hard to replicate in listed markets. This package can be customized for any client who needs to customize their view without needing to create a complex option strategy themselves. 
• Enhanced diversification and the potential to help manage portfolio risk. Structured products may provide diversification, helping to complement traditional asset class allocations, and potentially providing outperformance versus traditional asset classes. Structured products that offer a downside buffer may help some investors manage risks in their portfolios and remain invested.

How might investors fund structured products?

There’s no one-size-fits-all answer. Structured products are customizable strategies, so the right approach depends on investors’ portfolio and wealth goals. 

Investors can fund structured products in several ways. Using excess liquidity may make sense if you have cash on the sidelines and are uncomfortable with the risk of holding cash during inflationary periods, or times of declining cash returns. If you are a more income-oriented investor—if you’re seeking more yield in your portfolio—structured products may offer the potential to enhance income while seeking to mitigate portfolio risk. This approach is often funded from fixed income allocations.

As noted, a downside buffer is a popular use case, and if the priority is to limit downside risk while maintaining market exposure, structured products can be funded from multi-asset or equity allocations.

Risks to consider 

Understanding the risks of structured products is essential. Your wealth goals will influence how much risk you’re comfortable taking in pursuit of higher returns. Risks include, but are not limited to:

• Market risk. The underlying asset’s value performance can fluctuate, impacting the value of the note. Structured products are typically “buy-and-hold” vehicles with set maturities (typically one to two years). The structured note’s performance will typically lag the underlying asset’s until maturity. In certain transactions, investors may lose their entire investment (i.e., incur an unlimited loss).
• Credit risk. Products are issued by a bank, so the structured product’s reliability depends on that issuer’s creditworthiness. If the issuer faces financial trouble, you may be exposed to credit risk similar to if you were holding that company’s bond.
• Liquidity risk. Structured products are traded over the counter and do not encompass a liquid resale market (so selling them quickly without a loss would be difficult). The issuer typically sets the price.

Structured products may not be suitable for everyone. If you prefer to trade in and out of investments frequently, or if you’re uncomfortable with complexity, these instruments may not be the right fit.

But for many investors, structured products may be designed to help manage risks and offer customizable risk-return profiles. They’re not a promise of future success, but a thoughtful strategy for those seeking to address the specific challenges in times of market drawdowns and enhanced volatility.