Your Guide to the Weird, Wonderful, and Occasionally Terrifying World of Structured Products
Making things understandable
After quite a few questions from readers on Structured Notes, and some interesting innovation on the ETF front (see below), we will take a journey through the wide world of structured products today.
Everything in finance is a derivative. Well, not everything. But a lot of the interesting stuff is. The basic art of modern finance is taking a couple of simple things people more or less understand a stock, a bond, an interest rate and then welding them together in a dark room with some complicated math to create a new thing. A new thing that is, ideally, more confusing and can be sold for more money.
Consider for a moment a hypothetical investment I just made up: the "Inverse Volatility Adjusted, Rainbow Barrier, Shark Fin Note on a Basket of Meme Stocks and Turkish Lira." What does it do? Who knows! But it sounds exciting doesn't it? Like something a person in a very expensive suit would sell you. The beauty of it is that its performance isn't based on some fund manager's gut feeling; it’s determined by a cold, hard mathematical formula. If the VIX does X, and the worst performing meme stock avoids breaching its 60% barrier on the third Tuesday of the month, while the lira doesn't, you know, hyperinflate more than usual then you get a 12% coupon. Simple!
And that, in a nutshell, is the world of structured products. They're prepackaged investment strategies that promise a specific, defined outcome based on what some other asset does. The financial equivalent of a Rube Goldberg machine designed to produce a return.
And they are everywhere. The global market is measured in trillions of dollars yet many professional investors have barely heard of them. They have a history of being opaque, expensive, and occasionally blowing up in spectacular fashion. But they're also undergoing a revolution. The innovation that was once the exclusive domain of private banks is now becoming accessible to everyone largely through the magic of exchange traded funds (ETFs).
So we're going to take a deep dive. We’ll look at what these things are, where they came from, and why your banker in Zurich might offer you something completely different from your broker in Des Moines. We'll talk about who makes money on them (hint: it's a systematic wealth transfer from you to the bank) and discuss the time they helped burn down the global financial system (sort of). And finally, we'll explore how technology and the ETF wrapper are dragging this weird, esoteric corner of the market into the light and ask the ultimate question: should you actually buy one?
So, You Want to Buy a Financial Product That Isn't a Stock or a Bond
At their core, structured products are financial smoothies. You take two basic ingredients one boring, one spicy and blend them together to create a new concoction with a very specific flavor profile. The two ingredients are almost always a bond and a derivative.
The Basic Recipe: A Financial Smoothie
The first ingredient is the bond. This is the sensible, nutritious kale of your financial smoothie. Often, the bank that creates the product will take the bulk of your investment say, $90 out of every $100 and use it to buy a zero coupon bond. This is a special kind of bond that doesn’t pay interest along the way. Instead you buy it at a discount to its face value, and at maturity, it pays you the full amount. So the bank buys a bond for $90 that will be worth exactly $100 in, say, five years. Voilà, your "principal is protected." The bond component is the part that guarantees you get your initial investment back when the product matures. Assuming, of course, the world doesn’t end.
The second ingredient is the derivative. The ghost pepper in your smoothie. It’s what gives the product its kick. The bank takes the leftover money from your investment that $10 that wasn't used for the bond and goes to the financial casino to buy some options. Instead of giving you that interest, the bank uses it to buy a call option on a stock market index, say, the S&P 500. This option gives you the right, but not the obligation, to benefit if the index goes up. This is how you get "upside participation".¹
This simple combination a safe bond to return your principal and a risky option to generate returns is the fundamental building block of almost every structured product on the planet.
The Cynical History: It's All About Cheap Debt
Structured products were born out of a primal Wall Street need: the desire for companies to borrow money more cheaply. The ancestor of the modern structured product is the convertible bond. A company would go to investors and say, "Look, instead of paying you a 5% coupon on our new bond, how about we pay you 2% and give you the right to convert your bond into our stock if the price goes up?". In exchange for the potential upside of the stock (the option), investors would accept a lower interest rate. From the company's perspective, this was great; it was a way to issue debt at a sub market rate.
Investment banks looked at this and thought, "We can do that, but way more complicated." They started issuing their own debt called "notes" with all sorts of bells and whistles attached, linked to anything and everything: stock indexes, commodities, you name it. The goal was the same: give investors a reason to accept a lower interest rate on the bank's debt in exchange for some other feature. This reveals the fundamental nature of these products. They are not just an "investment" you buy; they are a funding tool for the banks that issue them.
The Most Important Thing You'll Read in This Article: Credit Risk
This brings us to the single most important, most misunderstood, and most dangerous aspect of structured products. A structured note is an unsecured debt obligation of the issuer.
Let's break that down. "Debt obligation" means it's an IOU from the bank. "Unsecured" means that promise is not backed by any collateral. If the bank that issued your note gets into financial trouble and goes bankrupt your "100% principal protected" note is just another piece of paper in a very long line of papers held by people the bank owes money to. As an unsecured creditor you stand behind the secured creditors, and you might get back pennies on the dollar. Or nothing at all.
Your "principal protection" is only as good as the financial health of the bank that promised it. This is not a theoretical risk. This is the risk that vaporized billions of dollars of "safe" investments in 2008, a story we will return to later.
A World Tour of Weird Notes
The strange financial smoothies we call structured products are consumed all over the world, but local tastes vary dramatically. The product menu in Frankfurt looks very different from the one in Hong Kong, which looks different again from the one in New York.
Europe is the old country, the birthplace of the structured product, and it's characterized by a truly staggering number of new products issued each year. Germany and Switzerland are the undisputed kings, with a market that evolved from a historical love of highly leveraged products for speculative trading. The regulatory environment is famously prescriptive, mandating things like a Key Information Document (KID), a standardized, three page summary meant to make these complex products understandable.
Asia Pacific is the new king of volume, accounting for over 72% of global sales in 2019. The market is dominated by a powerful demand for income, with yield enhancement products being particularly popular. The culture is often described as more relationship driven, with products tailored and sold through vast networks of private bankers.
The United States is a different animal. The retail market has historically been smaller and more cautious, partly due to stricter consumer protection regulations. But that's changing fast, with sales volume more than doubling in the four years leading up to 2021. The market has one undisputed champion underlying: the S&P 500 index. The real story in the US is the great migration away from traditional bank issued notes and toward the transparent, liquid world of exchange traded funds.
The Product Menu: A Field Guide to Financial Frankensteins
While there are countless variations, most structured products fall into a few broad families. Let's dissect the three most common species.
Principal Protected Notes (PPNs) - The "Heads I Win, Tails I Don't Lose" Dream
The Pitch: This is the classic story. You get the upside of the stock market with the safety of a bond. If the market soars, you participate in the gains. If the market crashes, you get your initial investment back at maturity.
The Mechanics: This is our basic financial smoothie recipe. The bank takes most of your money to buy a zero coupon bond and uses the rest to buy a call option. But there's no free lunch. To pay for that protection, you give things up. You get no dividends, and your upside is usually limited by a "participation rate" or "cap".
The Catch: The "protection" is just a promise. An unsecured IOU from the issuing bank.
Reverse Convertibles (RCNs) - Getting Paid to Sell Insurance
The Pitch: An RCN offers a juicy, above market coupon in exchange for taking on a little bit of stock risk.
The Mechanics: If a PPN is about buying an option for upside, an RCN is about selling an option for income. When you buy an RCN, you are effectively selling a put option to the bank. The big coupon you receive is the premium the bank pays you for selling them this option.
The Catch: If the underlying stock linked to your note falls below a certain price (the "strike price" or "knock in barrier"), the bank can exercise its option. At maturity, instead of giving you your cash back, the bank has the right to pay you in a predetermined number of shares of that now much cheaper stock.
Autocallable Notes - The Rube Goldberg Machine of Investing
The Pitch: This is the most popular type of structured product in many parts of the world. It offers high potential coupons and an exciting feature: your investment might mature early if the market performs well.
The Mechanics: This is a "path dependent" product. The note has a series of periodic "observation dates." On each of these dates, if the underlying index is at or above its initial level, the note is automatically "called." This means the investment ends, and you get your principal back plus a handsome coupon.
The Catch: This structure has two clever traps. First, there's reinvestment risk. The note is designed to be called in a rising market, so you get your money back precisely when it's a bad time to reinvest. Second, if it reaches its final maturity date and the underlying index has fallen below a downside protection barrier, you lose principal.
Who's Making Money Here? (A Brief Interlude Featuring the Ghost of Lehman Past)
In any financial transaction, it's wise to ask yourself, "Who is on the other side of this trade?" With structured products, the answer is simple: you are on one side, and a very large investment bank is on the other. And the game is rigged.
The Bank Always Wins (Usually)
Banks make money on structured products through a systematic and opaque wealth transfer from you to them. There are rarely explicit fees. Instead, the bank's profit is embedded directly into the product's structure. The most straightforward way is through the spread between the price you pay and the note's actual value. Every structured note prospectus will include an "initial estimated value." This value is almost always less than the $1,000 per note you paid. The difference represents the bank's built in profit. You are, in effect, buying the product for more than it's worth on day one. The product's complexity is their best friend, making it nearly impossible to shop around for a better deal. This isn't a cost; it's the entire point of the product from the bank's perspective.
Case Study: The Lehman Brothers Implosion
This brings us to the ghost at the feast: Lehman Brothers. The collapse of Lehman in September 2008 provides the most brutal lesson on the true nature of the risks in structured products.
The Pitch: In the years leading up to the crisis, Lehman Brothers sold billions of dollars worth of Principal Protected Notes to retail investors. The marketing was clear: these were "100 percent principal protected," "safe," and "conservative" investments.
The Reality: Lehman was a house of cards, massively over leveraged and drowning in toxic subprime mortgage assets. The "principal protection" was nothing more than an unsecured promise from a company that was hurtling toward insolvency.
The Scandal: When Lehman filed for the largest bankruptcy in US history, all of its unsecured debt obligations—including its PPNs—became effectively worthless overnight. Investors who thought they had bought a safe investment suddenly found themselves as unsecured creditors in a messy bankruptcy proceeding, eventually recovering only a fraction of their investment.
The Lehman PPN failure wasn't a "black swan" event. It was the inevitable outcome when the product's primary design flaw—its total reliance on issuer creditworthiness—collided with a financial crisis.
The Future Is Here, and It's Traded on an Exchange
For decades, the structured product market operated in the shadows. Buying a note was an over the counter (OTC) affair, a bespoke transaction between you, your broker, and a bank's trading desk. The process was opaque, the pricing was whatever the bank said it was, and once you owned the note, it was about as liquid as a block of concrete.
The 2008 financial crisis sparked a global regulatory crusade for transparency. The G20 leaders declared that all standardized OTC derivatives should be moved onto exchanges. This shift paved the way for the single biggest innovation in the structured products space: the ETF. The exchange traded fund wrapper offered a near perfect solution to the traditional note's most glaring flaws. ETFs are liquid, transparent, and generally have lower, more explicit costs.
The New Kids on the Block
This "ETF-ification" has led to a Cambrian explosion of new products that bring defined outcome investing to the masses.
Buffered ETFs (aka Defined Outcome ETFs): These are the most direct descendants of structured notes. A buffered ETF uses options to provide protection against a certain amount of market decline—the "buffer"—in exchange for limiting the potential gains to a "cap". For example, a fund might offer protection against the first 15% of losses in the S&P 500 over a one year period, but cap the upside at 18%. These products brilliantly solve the two biggest historical problems: there is no single issuer credit risk (the fund's assets are segregated), and there is daily liquidity on a stock exchange.
Covered Call ETFs: These funds own a portfolio of stocks and continuously sell call options against them. The premiums received from selling the options are then distributed to shareholders as income. They have become wildly popular in the hunt for yield, offering tantalizing distribution rates. Their main trade off is that by selling call options, they cap their upside potential, causing them to underperform in a strong bull market.
Spotlight on Innovation: The Calamos Autocallable Income ETF (CAIE)
The latest frontier is to take the most popular and complex structured product of all—the autocallable note—and cram it into an ETF wrapper. The Calamos Autocallable Income ETF (CAIE) is a prime example. But here's the beautifully convoluted part. Instead of buying the notes, the ETF makes a side bet with a bank on how a fantasy league of autocallable notes would perform. The ETF holds ultra safe US Treasury bills and then enters into a total return swap with a bank like JP Morgan. This swap is the bet: the ETF gets the fantasy league's winnings (or losses) without ever having to own the players (the notes themselves).
It's financial abstraction at its finest. The pitch is compelling: it aims to democratize an institutional strategy, deliver a high and stable stream of monthly income, and wrap it all in a liquid, tax efficient ETF. It solves the old problems of liquidity and single issuer credit risk, but it introduces a new, more subtle one: counterparty risk on the swap.
The Old Way vs. The New Way
Traditional OTC Structured Note
Liquidity: Very low. Designed to be held to maturity.
Transparency: Low. Pricing is opaque, determined by the issuer's internal models.
Issuer Credit Risk: High. Your entire investment depends on the solvency of the single issuing bank.
Fees & Costs: High and opaque. Embedded into the product's price.
Accessibility: Limited. Often high minimums and sold through brokers.
Customization: High. Can be tailored to a specific client.
Structured ETFs (e.g., Buffered ETFs)
Liquidity: High. Traded on a stock exchange like any other ETF.
Transparency: High. Intraday pricing is visible on the exchange.
Issuer Credit Risk: Low/None. As a regulated fund, assets are segregated.
Fees & Costs: Lower and transparent. Stated as an annual expense ratio.
Accessibility: High. Can be bought for the price of a single share.
Customization: Low. Standardized, "off the shelf" products.
The Final Verdict (This Is Still Not Financial Advice)
So, after all that, are they worth it? For most people, the answer for traditional, bank issued structured notes is a resounding no.
The entire premise is flawed. They are a complex, expensive solution to a simple problem: fear of volatility. The historical evidence is clear: these products are systematically overpriced at issuance, meaning you are paying $1 for something worth 95 cents the moment you buy it. That difference is the bank's profit, extracted from you through complexity and opacity. The forgone dividends, capped upside, and unfavorable tax treatment create a massive, persistent drag on long term returns.
The sales pitch often leans on a behavioral argument the "protection" keeps you from panic selling in a crash. This is a deeply cynical proposition. It's like saying the best way to teach a child not to touch a hot stove is to sell them a very expensive, underperforming pair of oven mitts. It treats the symptom fear while ignoring the cure: education, discipline, and a sensible long term plan. It's an expensive substitute for good behavior.
The evolution of this market toward ETFs is a massive step in the right direction. Buffered ETFs and their cousins solve the most terrifying problems of the old model: single issuer credit risk and illiquidity. They are more transparent, cheaper, and more accessible. They are a necessary and welcome market correction.
But even in their new, improved form, they are a specialized tool, not a core holding. For a young investor with decades to go, the cost of capped upside is simply too high. Over the long run, the best protection against volatility is time, and simply owning a low cost S&P 500 index fund and riding out the storms has proven to be a far more effective wealth building strategy.
Structured products can make sense in niche situations perhaps for a pre retiree desperate to avoid a crash in the five years before they stop working. But for the most part, they are a fascinating, cautionary tale about financial engineering. They show how Wall Street can take simple ingredients, add complexity, and create a product that is far more profitable for the seller than it is for the buyer. The golden rule, as always, applies: if you can't explain it to someone else in a couple of sentences, you probably shouldn't own it.
¹ For the finance nerds in the room, yes, we are intentionally ignoring the Greek alphabet soup of vega, theta, and gamma. Just know that the price of the ghost pepper is largely determined by how scared the market is (volatility) and how much time is left on the clock. We now return you to your regularly scheduled smoothie analogy.