What it means
A typical structured fund runs for a fixed period, such as five years, and states in advance how the payout at the end will be worked out. For example, it might return the full original amount plus 70% of any rise in a stock index.
The manager does not pick shares; instead, the fund is engineered to deliver that payout. The engineering uses two building blocks.
Most of the money is placed in safe bonds that grow to the protected amount by maturity, and the rest buys derivatives, such as call options, that capture the market gains. The split depends on interest rates at the start, which is why the terms offered change over time.
The appeal is that investors know the rules, and the worst case is limited, at least on paper. Cautious investors who want some market exposure without the risk of large losses can find this attractive.
The trade-off is that the investor gives up part of the gains, usually through a participation rate below 100% or a cap on the return. There are important risks.
The protection normally applies only if the investor holds to the end of the term, and selling early can mean taking a loss. The guarantee depends on the financial strength of the bank or institution providing the derivatives, so the fund carries counterparty risk, meaning the risk that the other side of a contract fails to pay.
Fees are another factor, because structuring and distribution costs are built into the terms. Investors should compare the net outcome with simply holding a mix of bonds and an index fund.
Fund documents set out the payout formula and all costs, and they should be read in full before investing. Structured funds are related to structured notes, but a fund holds a basket of assets managed to a mandate.
A note, by contrast, is a single debt security issued by a bank.
In practice
Real-world examples.
Example
A retired teacher wants to put $50,000 in the stock market but cannot bear a loss of capital. Her adviser suggests a structured fund with full capital protection at maturity and a 60% share of index gains. She understands that she may earn nothing over five years in a flat market.
Example
A family business with surplus cash of $400,000 wants a known maximum downside over a three-year period. Its finance manager chooses a structured fund that returns the original amount plus a share of the gains up to a cap. She records the investment at fair value in the accounts.
Example
A bank's wealth management team designs a structured fund that pays a fixed bonus if a commodity index ends above its starting level. Its pricing team checks the cost of the options to ensure the product is viable after fees.
Formula
Calculation
Payout at maturity = amount invested x (1 + participation rate x index return), where the payout cannot fall below the protected amount
Suppose an investor puts $100,000 into a five-year structured fund with 100% capital protection and a 70% participation rate. If the index rises 20% over the term, the payout is $100,000 x (1 + 0.70 x 0.20) = $100,000 x 1.14 = $114,000. If instead the index falls 15%, the protection applies and the payout is $100,000. These figures ignore fees and assume the provider meets its obligations.Case study
Seen in the real world.
Thornbury Wealth is an illustrative, fictional adviser whose client, a small manufacturer, had $250,000 to invest for six years before buying new machinery. The owner worried about losing capital but wanted more than a bank deposit could offer.
The adviser proposed a structured fund with capital protection at maturity and a 75% participation rate in a global share index. She also explained the fees, the risk that the provider could fail, and the fact that early withdrawal could mean a loss.
At maturity the index had risen 24%, so the client received $250,000 x (1 + 0.75 x 0.24) = $295,000. The illustrative lesson is that the structure delivered the promised outcome, but the client gave up 25% of the market gain in return for protection.
Watch out
Common mistakes.
- Assuming that capital protection is absolute, when it normally applies only at maturity and depends on the provider's ability to pay.
- Ignoring the cost of the protection, which comes from the share of gains the investor gives up.
- Selling before maturity and expecting the protected value, when the early sale price may be lower.
Questions
People also ask.
How is a structured fund different from a normal fund?
A normal fund is managed to follow a market or a strategy, while a structured fund is built to produce a pre-set payout formula at the end of a fixed term.
Who bears the risk if the provider fails?
The investor does, because the protection is only as strong as the institution behind it.
Are structured funds suitable for everyone?
They suit investors who understand the terms and can hold to maturity, but they can be expensive and complex for others.
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