As opposed to buying common stock or bonds issued by, say, GE, structured products are created and sold by financial intermediaries with terms mutually agreed upon by both parties.
We have looked at both bonds and ETFs in earlier sections. An ETN (Exchange Traded Note) has characteristics of both a bond and an ETE an ETN is a type of unsecured debt security issued by a financial institution, e.g., Barclays Capital. This type of debt security differs from other types of bonds and notes because ETN returns are based upon the performance of an underlying benchmark minus fees. The benchmark could be a market index, a foreign currency, or commodities. No coupon payments are distributed during the investor's holding period and no princi¬pal protections exist. The issuer is borrowing the investor's money for a certain time frame, paying it all back (we hope) with interest at maturity, with the rate of interest dependent on the performance of the benchmark.
At maturity, the issuer pays the investor a sum of money based on the performance of the benchmark, investor fees, and the calculation explained in the prospectus for the ETN. During the holding period, the value of the ETN fluctuates primarily based on two factors: the performance of the benchmark and the creditworthiness of the issuer.
As with any bond, if the issuer's creditworthiness drops, so does the value of the security. ETNs can be traded on the secondary market, but, as with anything that can be traded on the secondary market, the price received could be less than what the investor paid. And, ETNs are generally not as liquid as stocks, bonds, and money market securities.
The test might say ETNs are subject to market risk, credit risk, and liquidity risk.
While ETFs invest in securities that allow them to track the underlying benchmark, ETNs do not own what they are tracking.
OTC options are exotic options traded on the over-the-counter market, where participants can choose the characteristics of the options traded (offers flexibility).
HOLDRs are a financial product created by Merrill Lynch and traded daily on the American Stock Exchange that allows investors to buy and sell a basket of stocks in a sector, industry or other classification in a single transaction. The abbreviation stands for Holding Company Depository Receipt. There are currently 17 different HOLDRs currently trading on AMEX.
HOLDRs are often confused or lumped in with ETFs. As Think Advisor explains, "Essentially, a HOLDR is a static basket of stocks selected from an industry. As a result, HOLDRs do not track an underlying index like ETFs, and represent a rather narrow slice of an industry. Not only are HOLDRs completely unmanaged, their components almost never change. Furthermore, if a company is acquired and removed from a HOLDR, its stock is not replaced. This can result in even more con¬centration and added risk. In contrast, indexes that ETFs invest in can change and rebalance with some regularity, and generally contain more components. Such is the case with Barclay's 'iShares' and Vanguard's ETFs called 'VIPERs' (Vanguard Index Participation Equity Receipts), which collectively track Standard & Poor's and MSCI indexes."
The term leverage sometimes refers to borrowed money but more generally refers to an investment promising higher returns on a percentage basis due to increased exposure to risk. For example, in a margin account the investor takes on the risk of borrowing money at a rate of interest, hoping to receive twice the returns he would have made on a percentage basis by being twice as exposed to the risks of the market¬place. With call options speculators can make much larger percentage gains than on the underlying stock and do so by putting down just a percentage of the stock's mar¬ket price. On the other hand, options can lead to quick and painful losses when the speculator is on the wrong side of the market.
A leveraged ETF uses derivatives to increase the fund's exposure to the underlying index. Some funds are "2X," or exposed to the index in a way that will double the gains or losses. In other words, they are designed to go up or down 100/o if the S&P 500 or other index goes up or down just 5%. Some funds are even "3X," designed to triple the exposure to the index and, therefore, triple the gains (or losses) to investors.
Leveraged funds are only for the short-term. In fact, the exposure is re-set each trading day and designed to capture the 2 or 3X returns for just that one day. The products are really designed for institutional and other sophisticated investors due to their complexity and amplified exposure to stock, bond, or commodities markets.
ETF shares can be sold short, as the shares trade throughout the day alongside shares of any public company you care to name. This allows investors to hedge their market risk by betting against the overall market with a percentage of their portfolio. If a trader thinks the S&P 500 will drop today, he can sell an ETF tracking the index short. If he's right, he'll make some money with that speculation, which will offset whatever he loses on his stock portfolio.
Inverse ETFs are designed to bet against an index, and most such funds do so at a 2 or 3X multiplier by using derivatives. This means a leveraged inverse ETF is designed to move in the opposite direction of the index by a factor of 2 or 3. A 2X leveraged inverse fund is designed to, for example, rise 10% if the index drops 5%. Another name for a leveraged inverse fund is an "ultra-short fund."
As tricky as an inverse and leveraged ETF might be, we would have to nominate the Viatical or life settlement as the most alternative of all alternative investments.
The investment vehicle is created when someone with a life insurance policy wants to receive most of the benefit right now while he's alive. If the policy has a $1 million death benefit, the viatical settlement would involve the buy-side purchasing the pol¬icy for more than its cash surrender value but at a discount to the $1 million death benefit. The third-party buyer then becomes the owner of the policy, paying any premiums due. Then, when the insured dies, the investor collects the full death bene¬fit of $1 million.
But, wouldn't that imply that the sooner the insured dies the higher the investor's yield, and vice versa? Indeed. As we said—an extremely alternative approach to investing. A viatical settlement meets the definition of a security according to the state securities regulators. However, it is not liquid. If you purchase a viatical settlement, you may have to keep paying premiums, and you will only receive payment when the insured dies because there is no secondary market for these alternative investments. Unlike a bond investment, there is no annual return offered, and the actual return the investor receives is unpredictable since no one—except those relying on foul play—can accurately predict when someone is going to die.
The advantage is that this sort of investment would provide diversification to the investor. And, since death benefits are not taxable, the gain made upon payout is tax-free.
Mortgages are pooled and sold to investors through Ginnie Mae and Fannie Mae securities. Life settlements are sometimes pooled into "death bonds." Here, investors buy shares of a diversified pool of life insurance policies. As with an individual life settlement, the investors will profit based on how long premiums must be paid on the policies versus how soon the death benefits in the pool are paid out to investors.