A LITTLE INTRODUCTION ON STRUCTURED INVESTMENT PRODUCTS

The range of structured investment products available on the market has increased enormously in recent years. The market growth has been mainly investor-driven.

Islamic investment emerged as a response to rising investor demand in the Middle East in the 1970s and is now growing at an estimated annual rate of 15%. Over the years, liberalization of state policies in most Middle East and South East Asian countries have benefited the institutions; Islamic investment has also allegedly further developed in the wake of socially responsible investment and a revival of Islamic ideology as applied to investment ethics.

A structured investment product has no particular definition and generally, it involves the combination of various legal structures to achieve a certain solution or products matching investors’ requirements. Structured investment products are designed to facilitate highly customized risk-return objectives and used most often to protect principal, enhance returns and more closely align the investment with the investor's market and economic views. The ultimate goal is to develop an investment with a better risk-return outcome than its original underlying market exposure.

Structured investment products help investors pursue diversified portfolios without the complex credit, legal and operational issues that surround the execution of derivative strategies; address various market conditions and risk management objectives, e.g., protection, optimization, enhancing returns and leverage.

The range of structured investment products available is extensive. Most structured investment products fall into one of the four basic categories, ranging from relatively conservative investments to those that offer greater potential returns while taking on more risk, which are :

1) Principal protection

Principal protected structured products may be more appropriate for conservative investors seeking market exposure with principal preservation. A principal protected investment may be appropriate for investors unwilling to risk their principal or who have long-term financial obligations. These investors are willing to forgo some upside potential or yield in exchange for principal protection at maturity. These investments generally offer a return at maturity linked to an underlying such as a broad-based equity index or a qualified basket of stocks. Investors typically give up a portion of the equity appreciation in exchange for principal protection. Maturities often range from five to seven years, and clients should intend to hold the investments to maturity.

2) Enhanced yield

Enhanced yield structures may be appropriate for more risk tolerant investors seeking higher returns than comparable debt instruments. Payment at maturity on investments is determined by the performance of an underlying asset or group of assets and principal may be at risk. Here, investors generally forfeit partial or full principal protection at maturity in exchange for the potential to earn a higher participation. In exchange for accepting full downside exposure in the underlying, an enhanced yield investment offers double or triple the equity returns up to pre-specified maximum. Therefore, investors can be exposed to downside risk and may lose part or all of their original investment. Additionally, investors may receive shares of stock at a value below the original principal amount at maturity. Coupon payments and payment at maturity is subject to the credit risk of the issuer.

3) Access

Structured investment products can provide investors with access to an asset or group of assets not readily available to private investors. These products can offer exposure to markets or strategies that may be inefficient or difficult for investors to obtain, such as foreign exchange rates or commodities. Since these products may not provide for full repayment of principal at maturity and are typically linked to sophisticated underlying assets, they may be more appropriate for moderate to aggressive investors.

4) Leverage

Structured products that utilize leverage may be generally more appropriate for aggressive investors wanting to capitalize on a particular market view. These short term products provide partial or no principal protection but do offer the potential to receive leveraged returns on the value of the underlying asset. Some structures may offer additional leverage in exchange for capped or limited upside potential. Investors are exposed to downside risk of the underlying investment and may lose part or all of their original investment.

Islam encourages people to take business risks in return of reward and also encourages the earning of income rather than leaving funds inactive (which is the foundation of the legal maxim, al-ghorm bil ghonm). Since structured investment product, by its nature, is something that can deliver diverse risky cash flows to investors, it is a huge business. Thus, the Islamic structurers are also looking for ways to deliver the same cash flows, by using Islamic investment structured products to the Shariah-conscious Muslim investors. The main challenge for banks lies in structuring products in a Shariah compliant way, that requires strong innovation capabilities as well as a robust infrastructure to satisfy risk management and booking requirements of such investments.

In Malaysia, the first Shariah compliant structure was approved by the Securities Commission in 2006 and to-date, more than RM23 billion has been approved, where majority of the Islamic structured investment products are linked to performance of equities, profit rates, foreign exchange rates and fixed income instruments.

Usually, structured investment products need to be “wrapped” so that it could be used to create securities, making it legal and tax efficient. The same applies to Islamic structured investment products, where “wrapping” is necessary to make the product Shariah compliant.

Another pertinent fact to consider when structuring Islamic financial products is that not only must the desired payout profiles with their risk-return features be optimised, but strict care must be taken to ensure that the tripartite harmony with Shariah is observed, which means that the following three elements must all conform with Shariah, i.e.:

a) underlying

b) trading mechanism or investment strategy

c) packaging structure

In Malaysia, the regulatory requirements for issuance of Islamic investment structured products are clearly spelt out in the Bank Negara Malaysia and Securities Commission of Malaysia. Islamic products need to comply with the general regulatory requirements which include requirement for disclosures, suitability and fair dealing requirements and rating requirements; and most importantly, to adhere to the Shariah specific requirements.

The future looks bright for Islamic structured investment products. Financial institutions in countries such as Bahrain, the United Arab Emirates and Malaysia have been gearing up for more Shariah compliant financial instruments and structured finance, both on the asset and liability sides.

Shariah compliant products have long been treated as “Muslim only,” however, such perceptions no longer carry any weight as leading financial centres located in “non-Muslim” soils, e.g., Hong Kong, London, New York and Singapore, are making significant progress in establishing the legal and prudential foundations to accommodate Islamic finance side by side with the conventional financial system.