Structured products can round out a portfolio,
but they are complicated and potentially risky.
In this last article in a series, we
look at structured products. The first two articles examined life
settlements and structured settlements.
During the past few years, structured products have enjoyed steady growth. These complex instruments are designed to provide capital and income protection, diversification for portfolios and customized solutions for both institutional and increasingly retail markets. The largest issuers of these vehicles include large domestic and foreign commercial banks and investment firms like JP Morgan, Citigroup, Morgan Stanley, Merrill Lynch, Bear Stearns, UBS, Goldman Sachs and Wachovia Corp.
Structured products are popular in Europe, Canada, Latin America, Asia and Australia. Yet many wealth managers and financial advisors have never heard of them.
Just what are structured products and how do they work? What role, if any, could they play in your clients' portfolios? Structured products are hard to define. They can be a grab bag of different asset classes. But basically, the term is used to apply to anything that's structured. They usually include products linked to equity, fixed-income, indexes, interest rates, commodities, mutual funds and hedge funds. They generally, but not always, involve a complicated series of cash flow or derivative transactions.
"Typically, there is a particular aim involved, whether, for example, to raise money or reduce risk with respect to an asset, and a product can be structured to achieve that aim," says Lucy Farr, a partner in the New York law firm Davis Polk & Wardell, some of whose clients are issuers of structured products. "What makes them complicated is that they implicate a lot of complex and difficult concepts, including legal, tax, accounting and regulatory issues."
Structured products can be created and packaged by different institutions in various formats. JPMorgan, for example, has structured products with payouts tied to equities, interest rates, commodities, foreign currencies, mutual funds and hedge funds. They are being sold either as private placements or registered notes to institutions and retail customers. The product can be principal protected or income protected. If it's principal protected, it's usually a relatively safe investment while still offering the investor the opportunity to participate on the upside.
Issuance of structured products in the U.S. is growing rapidly. In 2005 new issues grew by 16% with nearly $50 billion in new structured products launched, according to the Structured Products Association (SPA), a newly formed trade group for the industry based in New York. In 2005, there were more than $12 billion in SEC-registered structured products issued and more than $17 billion in equity-linked certificates of deposits and private placements in the U.S. Although significant, the U.S. structured products market remains small compared to the European market, where issuances surpass $100 billion annually, according to the SPA.
Keith A. Styrcula, chairman and founder of the trade group, says growth in the industry in the U.S. today resembles that of hedge funds in the 1990s. "Six, seven years ago, many mainstream investors were just beginning to understand what a hedge fund is," Styrcula says. "The same could be said about structured products at this point in time."
For many retail clients, these products can be substituted for more traditional instruments, such as mutual funds, under the right circumstances. Some are sold in denominations as low as $1,000. For high-net-worth individuals, it's possible to have such products customized to fit a client's particular risk profile. "It's a creative way to monetize a view of an underlying asset with a payout that meets your client's needs, whether it's with principal protection or with a principal-at-risk structure," says Michael Camacho, managing director of structured investments at JPMorgan.
One such vehicle at JPMorgan is a "Return Enhanced Note" linked to the Nikkei-225 Stock Index with an 18-month maturity. With this product, if you expect the Nikkei to rise, you could potentially receive three times its performance at maturity, subject to a maximum total return of 40%. The downside risk is the same as owning the index.
Another product is a five-year certificate of deposit that provides full principal protection at maturity, and in addition, 100% of the upside performance of a global equity index basket consisting of the S&P 500 Index, the Nikkei 225 Index and the Dow Jones Euro Stoxx 50 Index. If the basket is negative at maturity you get only your principal back. "We tend to issue these in certificate-of-deposit form or as registered notes," says Scott Mitchell, a vice president in JPMorgan's Structured Investments group. "The benefit of the CD is that they are FDIC-insured, and they have an estate feature so if the holder dies the estate can redeem the certificate at par value."
Recently, JPMorgan rolled out a "Best of Constant Maturity Treasury" note, with a 3 1/2-year maturity that pays interest quarterly in the form of a coupon, based on whichever yield is highest among the two-year, five-year and ten-year Constant Maturity Treasury Rates at the time of the reset. Says Mitchell: "The interest rate is reset each quarter, the rationale being that the Note should outperform traditional LIBOR-based floating rate debt if the Treasury curve steepens." The product is being marketed as an alternative to a money market investment.
On the fixed-income side, Morgan Stanley has an inflation-linked note with a ten-year maturity. Every year it pays the investor a coupon, which is equal to the rate of inflation over one year plus 2.2%. So if inflation is, say, 4%, you would get a return of 6.2%. And if inflation spikes up to, say, 10%, you'd get 12.2%. By comparison, inflation savings bonds, or iBonds, are currently paying only 1% above inflation.
Some institutions have come out with structured products tied to commodities. They allow investors to obtain an efficient exposure to commodities, and can provide either partial or full downside protection. One example is a "Triple Appreciation Note" with a maturity of 18 months, which is linked to the Goldman Sachs Commodity Index Excess Return, being marketed by PNB Paribas.
How does it work? On the upside, if the index rises, the investor receives three times the percentage increase of the index, subject to a maximum of 30%. So, for instance, if the index was up 7% at maturity, your gain would be 21%. The investor is fully exposed on the downside, however, if the index loses value at maturity.
"If you're moderately bullish on commodities, such a note may allow you to outperform the market," says Serge Troyanovsky, a director in the equities and derivatives group at BNP Paribas in New York. "You get triple return on the upside, but you still retain full downside exposure."
Another product at PNP Paribas is a three-year, 100% principal protected product linked to a basket of commodities. Such a basket could contain individual commodities, such as precious metals, base metals, crude oil or heating oil and natural gas. If the basket increases in volume, investors get full participation of the upside. If the basket declines in value, on the other hand, you simply get your principal back with no loss, Troyanovsky explains.
Once primarily designed as investments for sophisticated institutions, these products have begun to filter down to the retail level. Some wealth managers and advisors are using or at least investigating them. Carl J. Kunhardt, a CPF with Quest Capital Management in Dallas, recently used a version of a structured product to facilitate a client's monetization of a concentrated position in company stock worth approximately $2.5 million.
As Kunhardt explains, his client was president of a large national company in Houston. "Due to his position, he maintained a significant number of restricted shares in the company. With his retirement, he recognized he needed to diversify his position, as we recommended. The challenge was that a majority of his shares were restricted, due to his position and the fact they had been offered through private placements as part of the executive compensation program. Also, because of the significant separation payouts he was receiving, we did not want to recognize the tax liability of such a large position in the same year.
"We recommended that he monetize his position through a prepaid forward contract. This structured product works similarly to traded options, but is done as a private transaction. Using the structured product department at our broker-dealer, we obtained a counterparty that would advance 100% of the current value and allow the client to participate up to 120% of the value ... the counter-party would keep any upside beyond this. The fee was built into the contract, which in effect provided the client with 87% of the value with upside potential. The length of the contract was one year."
Kunhardt says, "We've issued it before as a hedging strategy and will continue to use it as an out-of-the box alternative in bringing value-added to our relationships" with clients.
To be sure, not all advisors are enamored of these vehicles. Bob Rockwell, a CFP licensee with Cambridge Investment Research in Sandy, Ore., has investigated them and concluded: "It's expensive to protect your principal. In some products you're giving up 40% or more of your return in order to make sure you don't have a temporary loss. What I've found is my clients would rather put up with the volatility and get 100% of the market return taxed at the more favorable 15% capital gains rate, versus losing a larger percentage of their return and being taxed at the regular income tax rate."
Before putting your clients into any of these products, you should weigh their risks, which can include market and interest rate risk, embedded leverage and reduced liquidity, credit risk in respect to the issuer and uncertain tax treatment, says Anna T. Pinedo, a partner in Morrison & Foerster, a New York law firm that advises issuers of structured products and broker-dealers who market them.
Regulators also are eyeing these products. The NASD in October 2005 issued a notice that described its concerns, focusing on investor suitability and adequacy of disclosure.
Bruce W. Fraser, principal of Bruce
W. Fraser Communications in New York, has written for many
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