Structured product Hedge Funds

Structured Product Investments as “Hedge Funds”

Structured Product Hedge Funds

Are you being sold structured product as a hedge? There is more market volatility, so folks are talking about hedge funds. Or, not really hedge funds since private equity and venture investing seem to be the darlings now.

Due to market volatility, people are being sold structured products again.

What is a structured product, and why should you avoid them? Or, if you are convinced that they do in fact offer downside protection, what do you need to understand before investing? Is it better just to have a Fixed Indexed Annuity if you are looking for downside protection? What about a buffered ETF?

Let’s take a shallow dive into the complex world of structured product “hedge funds” and try not to drown. Do they act as a hedge? Do you need a structured product?

Complexity In Hedge Funds

First, note that structured products are some of the most complex products out there. By definition, you—the individual investor—will not thrive in a world of such complexity.

Sure, you might do ok, but you can be sure your advisor, the bank, investment or insurance company, and many others will be skimming money along the way.

Complexity does not favor the individual investor. Occam affords good advice on the topic, and you are best keeping things as simple as you can to afford your investing goals.

That said, folks worry about market volatility and are interested in “downside” protection. Others, closer to retirement, look to take risk off the table. Structured products profess “no losses” yet the ability to “participate in the upside.” What gives? Is the complexity worth the hedge?

What are Structured Products?

There are many different types of structured products. So what are structured product investments? For starters, let’s look at a simple version meant to eliminate downside risk yet offer higher returns than mere fixed income products.

That, fundamentally, is the goal of these products: to lower both the risk and the reward of investing.

The Basics of a Structured Product?

A structured product is a combination investment that includes fixed income and derivatives. Usually they are used as a hedge. A Hedge is a position that offsets the risk of some other position. Say you feel that you have a lot of stocks right now. By hedging, you limit the risk in that investment.

Here are the components of a Structured Product:

Fixed Income

Income generated by these investments needs to “guarantee” against losses. These fixed income products are commonly government bonds (including STRIPS or Zeros), corporate bonds, or CDs.

Derivatives

The income purchases options from the fixed income investments or the amount above the fixed income need to guarantee no loss. These options expire worthless if the index is flat or goes down, but pay if the index goes up.

Hedge

The fixed income “floor” ensures you get your money back, and the difference is used for derivatives that increase your return when the index goes up.

Therefore, there is only upside and you don’t have a risk of losing your principle. When the underlying index does well, you benefit. If it tanks, your options expire worthless, but you don’t lose any money! (Except expenses are eating away all the while.)

Let’s look closer to see this in action.

Structured Products in Action

Fixed Income

structured product hedge funds

Figure 1 (Fixed income in Structured Product Investments)

You can see in figure one we invest in zero coupon bonds. Zeros don’t pay income, but over time they pay you more than you put in. So, say for this example we needed to guarantee 100% of our money back, but only needed to invest 90% of our money to do so. Now we have a “floor” or a guarantee, and can spend that 10% on something else. What do you want to spend it on?

Underlying Option

hedge products

Figure 2 (Underlying option in a Structured Product)

We take that extra, say 10%, and buy options. Figure 2 shows the possible returns for this option when we buy it at the grey vertical line.

Left of this line (that is, the market is down), we don’t lose any money because the option expires worthless! This is represented by the blue horizontal line.

If the market is up (to the right of the gray vertical line), we make money along the blue line.

So with this option, we cannot lose money (more than what it cost us to buy it!) and we have the potential for upside growth.

What happens when you put the two together?

Hedge Products Graph

hedge products

Figure 3 (Graph of Hedge Products)

Now we can see the payment at maturity on the left and the return of the index on the bottom.

Our returns are in blue again. If the market is at -30% or 0%, we don’t lose any money because we have the Zeros flooring our return and the options expire worthless. As the market gets positive returns, we make more money!

Eventually the amount we make reaches its limits as the options top out. This is why there are “caps” and “spreads” to fixed indexed annuities, because the options can only produce a certain amount of income. But we will mention fixed index annuities later.

Let’s look at another way to visualize structured products because they are tricky to understand.

Visualize Structured Product Hedge Funds

visualize structured product hedge funds

Figure 4 (Another way to visualize structured product hedge funds)

Source 

Let’s look at figure 4 for another way to view structured product hedge funds. Note in light blue, we have CDs or Zeros that, over time, return 100% of our principle investment. So there is no loss!

Then, in dark blue, we have extra money that we can invest in options. If there is positive return in the market, the extra money we have on the left provides the extra returns on our right. If the market returns zero, you don’t get the dark blue bar on the top, but you are still left with 100% of your investment! Minus, of course, expenses for the structured product investment!

And structured product investments are expensive! But before we talk about that, let’s talk about Fixed Indexed Annuities.

Fixed Indexed Annuities are Structured Product Hedge Funds

The darling of the annuity world, Fixed (or Equity) Indexed annuities are structured product investments with the additional backing of the insurance company guaranteeing the product.

This additional backing is not free, and FIAs can be even more expensive that structured products.

They are pitched: participate in growth of the index with no downside!

As we see above, they buy fixed income and use the difference to invest in options on indexes just like structured product investments.

They say that you don’t pay the commissions for these products, which is to a certain extent true. If you invest 100k into a FIA, 100k is credited to your account. So how does the salesman get paid? The insurance company pays them the surrender charge if you leave early, and they make their money up through interest rate changes in the meanwhile.

How does that work? Say they get a return of 3% on the fixed income component of the investment. They only credit you with say 1% of that, and they keep the 2% difference to make money. So, you have less of your money working for you with FIAs than you might with other structured products. In addition, FIAs can have riders which charge you 1-3% of your account value for future opportunities, such as guaranteed withdrawal benefits or Long-Term Care insurance. There are many ways insurance companies make money off your “investment” in these complicated (or even incomprehensible) annuities.

And we haven’t even gotten to why you don’t need structured products or FIAs as a “hedge” yet.

How Structured Product Hedge Funds are Sold

You might read: For the conservative investor, they present intriguing alternatives to standard asset classes. Yet, they are bonds and options. Just packaged together for your investing entertainment.

There are many different bells and whistles to structured product investments which are not mentioned above. You can leverage these products to provide 2x the growth, or have less downside protection (say it stops losses at -10%).

So, on one hand, they can be sold to the nervous investor to “lock in” their growth. And on the other hand, they can be sold to investors who want to “express” how they feel about the market. If you think it is going to be sideways, you can invest in this structured product. If you think it is going to mostly go up but have volatility, you’ve got that structured investment.

Folks, we know something that works perfectly well to lock in growth. And it is not structured products.

Beyond that, we know “expressing” your opinion about what the market is going to do in the short term is nothing more than a fool monkey throwing darts at the dartboard.

Don’t use market-linked investments—that is structured products—to express yourself or to lock in the downside. There are less expensive and easier ways to hedge. It’s called asset allocation.

What are the risks involved in Structured Product Hedge Funds?

Not Liquid

There is no daily pricing or net asset value, and usually there is a surrender period and charge.

Extremely Complex

We have just scratched the surface with these products. Again, complexity favors the large company rather than the individual investor.

Credit Risk

With low interest rates, some products may have more risky fixed income products.

Tax Treatment

Complex and may be uncertain. Not infrequently there is phantom income.

Costs

They are expensive!

Pricing Transparency

Frequently none. You cannot compare these products apples to apples so you never know how one performs compared to another.

Dividends?

There are no dividends. You only own an option on the equities, no the equities themselves. Always remember the return is based upon the price of the index alone, and excludes dividends

Structured Product Investments are Hedge Funds: Why you don’t need one!

So, we now have a pretty good understanding of what structured product investments are and can decide if we need one or not.

Do they act as a hedge? Yes! Do you need a structured product investment to act as a hedge? No!

No, you don’t need a structured product investment. The reason: Money is Fungible.

That’s right! It comes back to the fallacy of mental accounting. You cannot rope off a section of your money and somehow treat it differently. All your investments are part of your asset allocation, even if you pay someone to put in a structured product.

With a structured product hedge fund, you own fixed income, options and a side of high fees. If you didn’t have the structured product and just had the fixed income, you would have an equivalent hedge as per your asset allocation. The fixed income part provides some income that “guarantees” a return on investment (minus credit risk, of course), and the equity component provides the potential for growth.

Just because you have some money set aside in a separate bucket called a structured product doesn’t mean the money behaves any different. Money is money, it doesn’t care where it came from or where it is going. It is all part of your overall asset allocation.

What To Do Instead of Structured Product Investments

Own bonds. Have a well constructed and thought out Asset Allocation.

But let’s not be overly dogmatic.

There likely is a place for a very nervous investor who cannot tolerate any market volatility to own a structured investment. Understand that structured products are bond-alternatives.

Equity-alternatives can also be an important part of your overall asset allocation.

Just understand you could create the same protection for yourself owning fixed income and equities as you can with a structured product investment.

That’s right. Equities do just as well (if not better) than options on equities over time. If you can just not sell low, if history is any guide, equities are perhaps the safest investment out there.

Buffered ETFs are likely better than structured investments anyway!

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3 Comments

  1. This is a good primer.

    Was having this discussion in a way the other day with a colleague. He was asking me my opinion, since I spent a good deal of my career in structured finance, whether there was ever a place for structured products.

    My answer was a qualified yes. I fully believe that structured products can be designed to fit the cash flow needs of certain corporate clients. You know who can really benefit from buying structured products? Insurance companies. You can match lumpy cash flow needs for one. I suppose (though I never thought about it when I worked there) that they also “benefit” by selling them.

    I can’t think of a reason why individuals would ever buy them.

  2. Great piece as usual David. Thanks very much! In my area (PA) there are incessant radio and TV commercials for “Crash Proof Retirement” and offers of free dinners with a seminar. For annuities..!

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