Structured products are extremely complex investment instruments. Structured products also come in many different varieties and can be sold directly to investors or embedded in mutual funds. Brokerage firms and brokers have recommended these investments to clients claiming that structured products are conservative investments that generate current income and carry a high credit rating.
At their core, structured products are all market linked derivative investments. A structured product generally references a source against which market risk is taken. The source can be a single security, a basket of securities such as a market index, commodities, or a real estate loan portfolio. The variety of products that can be structured demonstrates the difficulty in formulating a single unified definition of a structured product. In addition to the variety of sources of market risk exposure, many structured products also have leverage features or may set risk limits sometimes referred to “principal protection.”
Certain structured products, such as structured mortgage backed securities (MBS) and collateralized debt obligations (CDO) cannot be sold directly to retail investors but can be purchased by investment advisers and sold to investors through mutual funds or other investment vehicles. Structured MBS and CDOs tranche credit loans into slices in order to apply leverage and increase returns along with risk. A key goal of the tranching process is to create classes of securities whose credit ratings are higher than the average credit rating of the underlying loans.
Brokerage firms have an obligation to perform a reasonable basis suitability determination before recommending structured products to investors. In order to ensure that the structured product is suitable, firms must ensure that the investment is priced so that the potential yield is appropriate in relation to the volatility of the referenced asset based upon comparable or similar investments, in terms of structure, volatility, and risk in the market. Firms must also ensure that the structured product is suitable for the individual investor based upon the investor’s investment objectives.