Structured Products
Investment bankers and financial institutions have become very creative in the structured products that they design. They are designed to meet investor demand. Often special features are added that may relate to risk and return, such as principal protection. Some structured products are arranged to distribute tax efficient income. Nearly all of them have a targeted investment objective.
What is a structured product?
They are generally a pre-packaged investment strategy that may include a combination of investments and derivatives. The structure generally may be linked to the performance of an underlying security, or basket of securities, including Canadian common shares, preferred shares, US equities, global equities, income trusts, Canadian bonds, Global bonds, indices, commodities, foreign markets, mortgage-back securities, hedge funds, closed-end funds, exchanged traded funds, etc. The above linked assets may be combined with derivatives making structures more complicated to understand. Typical types of derivatives include options, forwards, and swaps.
Rather than explain the mechanics of derivatives we will explain the main reason why they exist. Derivatives exist to enable the transfer of risk from those who do not want to bear the risk to those who do. In other words, some investors may use derivatives to reduce risk (for a fee) while others may use them to increase risk and the potential for return.
How are they used?
Investors may look at structured products a number of different ways. They are generally an alternative to a direct investment. When people get excited about an asset class or a specific type of investment then financial companies are likely to respond by creating a structured product to meet the investment demand. Structured product may be added to a portfolio for diversification, coverage of different asset classes, different geography, lower correlation with other investment, etc. may all be good reasons. Certainly the products that offer some form of protection provide people a method of managing downside risk. As noted above, many structured products may also provide tax-efficient income.
Technology Example
During the technology boom in the late 90’s many people were following financial news and seeing incredible gains in this sector. Sophisticated and unsophisticated investors wanted to buy technology. Financial firms responded by setting up technology mutual funds and other structures linked to technology.
After the tech bubble and 9/11, many investors wanted to preserve their capital. Unfortunately, around this same time, fixed income investments such as bonds were barely staying ahead of inflation and taxes. Financial firms responded quickly by offering financial products with equity exposure and principal protection.
Trust Example
Prior to October 31, 2006, many investors were excited about income trusts. Several structured products were created to hold a basket of income trusts and provided investors an easy way to obtain diversification within this type of equity investment.
Retirement Example
Some companies have released income and segregated funds that are more complicated than previous series. Some of these funds are focused on creating retirement income and have different features that individuals should fully understand prior to making an investment.
Infrastructure Example
Some structured products are very interesting to read about. Take the recent “infrastructure funds” as an example. The average investor cannot simply go out and buy a road or bridge. Some of these structures allow individual investors access to these types of asset classes that have primarily been reserved for private equity and pension plans.
Other Examples
New structures are continually being created. Many of these structures may provide investors access to international investments. Other funds may have specific objectives including uranium funds, water funds, socially responsible investing, etc. A key point to remember is that with some types of investments or asset classes, structured products may be the easiest way to gain access.
Who uses them?
Although heavily marketed to the retail investor, their uses extend to all individuals regardless of net worth. Investors with small accounts may be attracted to the low minimum amounts required for initial investments. Other structures such as hedge funds are specifically marketed to high net worth individual.
Understand the Structure
Regardless of the amount people would like to invest, or their level of sophistication, an understanding of the structure should be obtained. This understanding should include how the investment objectives of the structure pieces into your overall plan. Take a detailed look at the risks and rewards, fees, and liquidity. Comparing structures issued by different companies may soon reveal the different options available.
Investors should only consider purchasing structures that they both understand and fit into the plan. We recommend people to avoid investments that they do not understand. You may from time to time miss out on a good opportunity; however, successful investing also involves avoiding poor investment decisions.
Split Shares
Some investors require growth from their investments while others desire income. Often at times an investment in common shares may offer both income and growth potential. A structure referred to as a “split share” attempts to separate these two components.
What is a split share?
A split share is a structure that has been created to “split” the investment characteristics of an underlying portfolio of common shares into separate components. This division may be done to satisfy the different objectives of investors. Typically, these structures consist of a preferred share and a capital share that trade separately in the market. Together these two securities are known as a split share.
The description “split share” may be confusing to some investors, especially since the preferred shares and capital shares trade independently. A key component to understand is that you do not have to own both components. Investors generally own either the “preferred” component or the “capital” component (some investors may own both). Conservative investors requiring income may find the preferred component more appealing. Growth oriented investors may find the capital component more appealing.
In a typical split share issue, the preferred share receives all the dividends from an underlying portfolio of common shares and is entitled to the capital appreciation on the portfolio up to a certain value. The capital share receives all the capital appreciation on the portfolio above what the preferred share is entitled to but receives no dividends. The capital component is generally considered “riskier” than the preferred component.
The following is an example of how a split share is created and how the returns are divided between the preferred and capital shares. As an example, a split share may be created by an investment firm by using existing common shares of publicly traded companies. Lets us a fictional company called XYZ Bank.
Split Share Illustration
We will assume that XYZ Bank’s common shares are trading on the TSX at a market price of $50.00 per share and pay an annual dividend of $1.50 (or three per cent dividend yield). To create a split share based on XYZ Bank, an investment firm purchases XYZ in the market and places them in an investment trust called XYZ Split Corp.
The trust then issues one XYZ Split Corp preferred share at a price of $25.00 for each XYZ Bank common share held in trust. The preferred share receives the entire $1.50 dividend from the XYZ Bank common share. This produces a dividend yield that is double that of the common share (six per cent versus three per cent) because half as much money receives the full common share dividend ($25 versus $50). In exchange for the higher yield, the preferred share is only entitled to the first $25 of the value of XYX Bank’s common shares that lie within XYZ Split Corp.
XYZ Split Corp also issues one capital share for each common share held in the trust. The capital share is priced at $25 and is entitled to all the capital appreciation in the underlying shares of XYZ Bank above $25 per share for the term of the XYZ Split Corp. As this illustration demonstrates, the two split share components are: one XYX Split preferred share plus one XYZ Split capital share equals one XYZ common share.
Looking at Leverage
There are many types of split shares as well as underlying investments. One fact that most split shares have in common is the leverage effect. Generally, at inception a split capital share offers approximately 2 times leverage. Unfortunately, this leverage also impacts investors in a down market, where a 25 per cent decrease in the underlying investment XYZ Bank may translate into a 50 per cent decline in the XYZ Split capital share value. A split share structure, especially the capital share component, should only be considered if an investor desires leverage. Do you use leverage in other components of your account? What is the position size relative to other investment in your account? What is your time horizon versus the term to maturity of the investment? This last question is important, as investors often require patience for leverage strategies to work in their favour.
Original Purchase
Split shares are originally offered through a new issue. After the new issue, both the preferred and capital shares trade in the market generally at a discount to their net asset value (i.e. the underlying common share). Investors interested in split shares would generally prefer shares that trade at a discount (or a very small premium).
Illiquid
Although the underlying investment(s) may have many shares exchanging hands each day, a split share may have very little trading activity. As a result the market for split shares is generally very illiquid making the purchase or sale of split shares difficult at times particularly with larger orders.
Maturity Dates
In recent years, many financial institutions have not issued “hard retractable” preferred shares, meaning that they have a set maturity date. Instead, perpetual preferred shares have been issued in their place, with no maturity date. Perpetual preferred shares are interest rate sensitive. As rates rise the underlying value of a perpetual may decline (and vice versa). A positive component to the preferred side of a split share offering is that the structure generally has a set term resembling maturity characteristics of a “hard retractable”. Terms for most split shares are generally five to seven years.
Underlying Investment
As with any investment, the main decision to purchase a split share should be based on the outlook for the underlying company over the term of the structure. Some split shares may be based on a basket of securities in one sector, index, etc. In these cases an investor should have a positive fundamental outlook for the underlying sector or index.
