Underlying investments

What Are Underlying Investments?

Underlying investments refer to the actual assets or securities upon which the value of another financial product, such as a derivative or a fund, is based. These core assets form the foundation of more complex financial instruments within the broader category of investment analysis and financial instruments. An underlying investment can be virtually any financial asset or tangible commodity, from a single stock or bond to an entire index of securities. The performance of the underlying investment directly dictates the value and performance of the related financial product. For example, the shares of stock that a call option gives the holder the right to buy are the underlying investment for that option.

History and Origin

The concept of underlying investments is as old as the earliest forms of financial contracts that derived their value from something else. While direct ownership of assets like commodities or land has existed for millennia, the formalization of "underlying" as a distinct concept gained prominence with the evolution of more complex financial instruments. Early examples include forward contracts on agricultural commodities, where the future price of a crop (the underlying asset) was agreed upon in advance.

The modern understanding of underlying investments became particularly critical with the growth of derivatives markets. These instruments, which appeared in nascent forms centuries ago, saw significant standardization and expansion in the 20th century. For instance, the creation of organized futures exchanges in the mid-19th century and, later, the formalization of options trading in the 1970s, solidified the need to clearly define the assets from which these contracts derived their value.

A prime example of the importance of understanding underlying investments emerged during the 2007-2008 subprime mortgage crisis. Mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) were complex financial products whose value was derived from pools of residential mortgages. When the underlying mortgages, particularly those extended to borrowers with poor credit histories, began to default en masse, the value of these sophisticated securities collapsed, triggering a broader financial crisis. The New York Times archives extensively covered the unfolding crisis, detailing how the decline in the value of these underlying assets led to widespread economic turmoil.

Key Takeaways

Underlying investments are the fundamental assets or securities that give value to more complex financial instruments.
Their performance directly influences the value of derivative products or pooled investment vehicles like funds.
Examples include individual stocks, bonds, commodities, and market indexes.
Understanding the underlying investments is crucial for assessing the risk and potential return of any derivative or structured product.
Transparency about underlying investments is vital for market stability and investor protection.

Interpreting the Underlying Investments

Interpreting underlying investments involves understanding the composition, quality, and risk profile of the assets that form the basis of a financial product. For instance, when evaluating an exchange-traded fund (ETF), an investor needs to examine the specific stocks, bonds, or other asset classes that the ETF holds in its portfolio. The ETF's performance will largely mirror the collective performance of its underlying holdings.

Similarly, for a derivative contract like a futures contract, interpreting the underlying investment means understanding the specific commodity, currency, or financial instrument that will be bought or sold at a future date. This involves analyzing the market dynamics, supply and demand, and any external factors that could influence the value of that specific underlying asset. A comprehensive understanding of these foundational assets allows investors to accurately assess the associated risks and potential rewards.

Hypothetical Example

Consider an investor, Sarah, who is interested in gold but does not want to physically hold the metal or deal with storage. Instead, she decides to invest in a gold ETF.

Choosing the Product: Sarah researches several gold ETFs and selects one that aims to track the price of physical gold.
Identifying the Underlying Investment: For this gold ETF, the underlying investment is physical gold bullion, held in vaults by the fund. The ETF issues shares that represent a fractional ownership of this gold.
Performance Connection: If the price of gold rises in the global market, the value of the ETF's holdings (the physical gold) increases, and consequently, the market price of the ETF shares will also tend to rise. Conversely, a fall in gold prices will lead to a decrease in the ETF's share price.
Risk Assessment: Sarah understands that her investment in the ETF is not directly in physical gold, but its value is entirely dependent on the market valuation of gold. She knows that while she avoids storage costs, she is still exposed to the volatility of gold prices, which is the risk associated with the underlying investment.

Practical Applications

Underlying investments are central to various aspects of finance:

Pooled Investment Vehicles: Mutual funds and ETFs hold portfolios of underlying stocks, bonds, or other assets. Investors in these funds gain exposure to the underlying holdings without directly purchasing each component. The U.S. Securities and Exchange Commission (SEC) provides investor bulletins explaining how ETFs function by holding underlying securities and tracking indexes.⁴,³
Derivatives Markets: Derivatives such as options, futures, and swaps derive their value from an underlying asset, which can range from individual securities to indices or interest rates. The Federal Reserve Bank of San Francisco offers insights into how derivatives transfer risk based on an underlying right or interest.²
Structured Products: These complex financial instruments, often tailored for specific risk-reward profiles, have their returns linked to the performance of one or more underlying assets, which could be anything from a basket of stocks to a specific market index.
Hedge Funds: Many hedge funds employ strategies that involve significant exposure to underlying investments through complex derivative positions or direct ownership.

Limitations and Criticisms

While underlying investments are fundamental to financial markets, the complexity and opacity of certain financial products built upon them can lead to significant limitations and criticisms.

One major criticism arises when the connection between the financial product and its underlying investments becomes obscure. This can make it difficult for investors to accurately assess risk, particularly in over-the-counter (OTC) markets where contracts are customized and less transparent. During periods of market stress, this lack of transparency regarding the quality and interconnectedness of underlying assets can contribute to systemic risk. For example, during the 2008 financial crisis, the intricate and often opaque nature of mortgage-backed securities and their underlying subprime mortgages made it challenging for financial institutions to understand their true exposures, leading to widespread loss of confidence. The Financial Times has reported on how the lack of transparency in OTC derivatives, tied to various underlying assets, can amplify systemic risks in the financial system.¹

Another limitation stems from potential mismatches between the liquidity of the financial product and its underlying investments. A product designed to offer daily liquidity might be backed by illiquid underlying assets, creating potential redemption issues if many investors try to withdraw their money simultaneously. Furthermore, the diversification benefits sometimes touted by complex products can be misleading if the underlying investments are highly correlated or concentrated, exposing investors to unforeseen risks.

Underlying Investments vs. Derivative Instruments

While closely related, "underlying investments" and "derivative instruments" represent distinct concepts in finance.

Underlying Investments: These are the foundational assets or benchmarks, such as stocks, bonds, real estate, commodities, or market indexes, from which the value of another financial product is derived. They are the actual assets that have intrinsic value.
Derivative Instruments: These are financial contracts whose value is derived from, or dependent on, the value of an underlying investment. Derivatives themselves have no intrinsic value; their worth is purely a function of the price movements of their underlying assets. Examples include options, futures, and swaps.

The key distinction is that underlying investments are the assets themselves, while derivative instruments are contracts about those assets. An investor might directly own an underlying investment (e.g., shares of a company's stock) or gain exposure to it indirectly through a derivative (e.g., an option on that company's stock).

FAQs

What is the most common type of underlying investment?

The most common types of underlying investments include stocks, bonds, currencies, commodities, and market indexes. These foundational asset classes are widely traded directly or form the basis for various derivative products and investment funds.

Why is it important to know the underlying investments of a product?

Knowing the underlying investments of a financial product is crucial because they directly determine the product's value, risk, and potential returns. Understanding these core assets helps investors assess the true exposure they are taking on, rather than just looking at the wrapper of the financial instrument. This transparency is vital for informed decision-making and risk management.

Can an underlying investment be illiquid?

Yes, an underlying investment can be illiquid. While many common underlying assets like major stocks are highly liquid, some underlying investments, such as certain types of real estate, private equity holdings, or specific bonds in niche markets, can be illiquid. If a financial product, like a fund or a structured note, is based on illiquid underlying investments, it can pose challenges for investors seeking to redeem or sell their positions quickly.

Are underlying investments only relevant for derivatives?

No, underlying investments are relevant for a broad range of financial products beyond just derivatives. They are fundamental to pooled investment vehicles like mutual funds and exchange-traded funds (ETFs), which hold portfolios of stocks, bonds, and other assets. Structured products, certificates, and even certain insurance products also derive their value from underlying investments.