Reference Product

A Reference Product (sometimes called a reference asset or Underlying Asset) is the specific financial asset, index, or benchmark that a financial instrument's value and performance are tied to. Think of it like this: if you place a bet on a horse, your betting slip is the financial instrument, but the horse itself—its speed, health, and performance—is the reference product. The slip is worthless without the horse, and its value is entirely dependent on the horse's outcome in the race. In the world of finance, the “betting slip” could be anything from a simple fund to a complex derivative, and the “horse” could be a stock, a bond, a commodity, or an entire market index. The key takeaway is that the value of the financial instrument you own is derived from the performance of something else—the reference product.

You don't have to look far to see reference products in action. They are the engine behind many common investment vehicles.

This is the most straightforward example for most investors. When you buy an Exchange-Traded Fund (ETF) that tracks the S&P 500, the reference product is the S&P 500 index itself. The ETF's job is to mirror the performance of its reference product as closely as possible. If the S&P 500 goes up 10%, your ETF should also go up roughly 10% (minus tiny fees). Here, understanding the reference product means understanding the health and prospects of the 500 largest companies in the United States.

Derivatives are where the concept gets a bit more adventurous. These instruments are designed for speculation and hedging, and their entire existence hinges on a reference product.

• Options: If you buy an Option contract to purchase Apple Inc. stock at a set price, the Apple stock is the reference product. The option's value will soar or plummet based on the real-time movements of Apple's share price.
• Credit Default Swaps (CDS): This is a more complex example. A Credit Default Swap (CDS) is like an insurance policy on a loan or bond. The reference product is the specific bond (e.g., a 10-year bond from Ford Motor Company). If Ford defaults on that bond, the CDS pays out to the holder. The value of the CDS fluctuates based on the market's perception of Ford's creditworthiness.

Structured Products are financial instruments engineered by banks, often combining elements of bonds and derivatives. Their reference product could be a single stock, a basket of international indices, the price of oil, or even the volatility of the market itself. The payout formulas are often complex, making it difficult to understand exactly how the product's value relates to its underlying reference product.

For value investors, the concept of a reference product brings to mind a core principle from Warren Buffett: “Never invest in a business you cannot understand.” When you buy a financial product, you must “look under the hood” and understand the reference product you are actually betting on. Ask yourself these simple questions:

• What am I really buying? Buying an ETF is not just buying a ticker symbol; it's buying a piece of the underlying reference product. Be sure you want to own it.
• Is the link clear? The link between an S&P 500 ETF and the index is crystal clear. The link between a complex structured note and its basket of obscure reference assets might be intentionally opaque. Simplicity is your friend; complexity is often where high fees and hidden risks reside.
• Is the reference product itself a quality asset? No amount of clever financial engineering can turn a bad asset into a good long-term investment. A derivative linked to a portfolio of shaky loans is still a bet on shaky loans.

Ultimately, a reference product is the fundamental source of value. As an investor, your job is to ignore the fancy packaging and focus on the quality of what's inside.