Structured Investments Products (SIPs): What are they and their examples

Structured Investments Products (SIPs): What are they and their examples
Structured Investments Products (SIPs): What are they and their examples

Structured Investment Products (SIPs): What Are They?

Investments with a tailored product mix that cater to the interests of individual investors are known as structured investment products, or SIPs. Derivatives are frequently used in SIPs. Investment banks frequently design them for hedge funds, institutions, or the mass market of retail clients.

Unlike a systematic investment plan (SIP), which aims to reap the long-term benefits of dollar-cost averaging by having investors make equal and regular contributions into a mutual fund, trading account, or retirement account, SIPs are not.

The Securities and Exchange Commission (SEC) updated its guidelines on December 9, 2020, with the goal of updating the framework used to gather, compile, and distribute market data for equities listed on exchanges that are part of the national market system. 

The SEC has established a decentralized consolidation model, among other enacted rules, wherein competitive consolidators, instead of the exclusive SIPs, will be in charge of gathering, combining, and providing the public with consolidated market data. 

Comprehending Structured Investment Products (SIPs)

The scope and complexity of a structured investment can vary, frequently based on the investor’s tolerance for risk. Derivatives and the fixed income markets are often exposed to SIPs. 

A structured investment typically begins with a traditional security, like a certificate of deposit (CD) or conventional investment-grade bond, and substitutes non-traditional payoffs—like periodic coupons and final principal—that are derived from the performance of one or more underlying assets rather than the issuer’s own cash flow. One type of structured investment product is a reverse convertible note (RCN).

A $1000 certificate of deposit with a three-year expiration date is a basic example of a structured product. Rather than providing regular interest payments, the annual interest payment is determined by the performance of the Nasdaq 100 stock index. 

The investor shares in the gain if the index rises. After three years, the investor still gets their $1000 back if the index declines. This kind of product combines a long-term call option on the Nasdaq 100 index with a fixed income CD.

2018 saw the Securities and Exchange Commission (SEC) start closely examining structured notes in response to public outcry over their exorbitant fees and opaque nature. 

In 2018, for instance, Wells Fargo Advisors LLC consented to pay $4 million and return unjustified gains to resolve SEC charges following the discovery that company representatives had intentionally pushed customers to purchase and then sell one of their structured products, which was meant to be purchased and held until maturity. 

The bank paid out large commissions as a result of the transaction churning, which also decreased investor returns.

NOTE

  • Investment banks design structured products, which combine one or more assets—and occasionally other asset classes—to generate a product that makes payments contingent on the performance of the underlying assets.
  • The complexity of structured goods ranges from very simple to quite complicated.
  • It is not always clear to investors how much they are paying for a product and whether they might make it for less money because fees are sometimes buried in rewards and small print.

The Rainbow Note and SIPs

Some investors are drawn to structured products because they allow them to tailor their exposure to various markets. A rainbow note, for instance, provides exposure to multiple underlying assets. 

Three relatively low-correlated assets, such as the Dow-AIG commodity futures index, the MSCI Pacific Ex-Japan Index, and the Russell 3000 index of US stocks, could provide performance value for a rainbow note. Furthermore, by “smoothing” returns over time, adding a lookback option to this structured product could further reduce volatility.

In a lookback instrument, the optimal value taken during the note’s period (e.g., monthly or quarterly) is used to determine the value of the underlying asset instead of its final value at expiration. 

This also corresponds to an Asian option in the realm of options (to differentiate the instrument from European or American options). Even more alluring diversification qualities can be obtained by combining these kinds of characteristics.

This demonstrates that structured products can be as complex as the more complicated version covered here, or as basic as the CD example given earlier.

Benefits and Drawbacks

One benefit of SIPs is that they offer diversity beyond standard investments. Additional advantages vary depending on the kind of structured product; these are product-specific. Principal protection, low volatility, tax efficiency, higher returns than the underlying asset offers (leverage), and positive yields in low yield situations are a few examples of these benefits.

One of the drawbacks is that complexity may present unanticipated risks. Although fees can be rather high, they are frequently concealed in the payout schedule or in the spread that the bank charges when opening and closing positions. The investment bank that is supporting the SIPs carries a credit risk. 

The SIPs typically have little to no liquidity, thus investors may not be able to exit before the SIPs mature at all, or they may have to accept the price the investment bank is offering. 

Furthermore, even while these products might provide some benefits to diversification, it’s not always clear why or in what situations they’re necessary outside of helping the investment bank that created them to make money on sales.

Structured Investment Products (SIPs) in the Real World

Assume, for illustration purposes, that a potential investor commits $100 to a structured product that tracks the performance of the S&P 500 stock index. The value of the structured product increases when the S&P 500 rises. However, the investor will still receive their $100 back at maturity even if the S&P 500 declines.

The bank charges any fees or makes money in multiple ways for this service. It might set a maximum amount that an investor can earn from, so any increase in the S&P 500 above that threshold represents the bank’s profit rather than the individual’s. The bank might impose additional fees. This might be incorporated into the rewards rather than being obvious. 

For instance, in order for the client to earn a 2% dividend, the S&P 500 may need to increase by 5% in the first year. The payoff falls proportionately if the S&P 500 increases by less than that. If the S&P 500 increases by 3% or less, the investor might earn nothing—that is, the bank’s profit.

This instrument is a call option on the S&P 500 index combined with a CD or bond. The bank has the opportunity to purchase call options with the interest it would have paid. In the event that the stock index rises, this preserves the initial investment while offering upside return possibilities. 

Additionally, the bank can hedge any exposure it might create on more intricately constructed instruments, so it usually doesn’t matter which direction the market goes.