Structured products are an improvised version of traditional investment products to facilitate highly customized risk-return objectives. This is accomplished by taking traditional security and replacing the usual payment features with non-traditional payoffs derived not from the issuer's own cash flow, but from the performance of one or more underlying assets.
Originally, structured products became popular in Europe and now are gaining popularity in the United States. They are now sold to retail investors in the same way as other security products. Their ability to offer customized exposure to otherwise hard-to-reach asset classes and subclasses make structured products useful as a complement to traditional components of diversified portfolios.
Generally, a structured product refers to an underlying source against which market risk is assumed. The underlying source could be a single security, a group of securities, commodities or a real estate loan portfolio. The range of products that can be structured shows how difficult it is to formulate a single unified definition of a structured product.
Structured products lack liquidity due to the highly customized nature of the investment. Lack of liquidity is always a bigger risk to investors. Moreover, the full extent of returns from such products is often not realized until maturity. Hence these kinds of products are a long term investment and not short term trading ideas. Another risk with structured products is the issuer’s credit quality.
Structured products have the ability to lose principal during a financial crisis much like the risks involved with Options. To mitigate the risk, market regulator Financial Industry Regulatory Authority (FINRA) suggests that firms do due diligence for buying and selling structured products similar to Options trading.
Another challenge for retail investors is to comprehend the pricing of such structured products. There is no uniform pricing standard to do a comparative study among products.
Brokers and brokerage firms must ensure that the structured product is suitable for the individual investor based upon the investor’s investment goals and risk appetite.