Two years after taking blame for Wall Street's crisis, structured products are finding a place in RIA portfolios
A column that makes the case for a much-maligned investment vehicle
Elizabeth’s note: Brooke and I confess to being among those people who had heard of structured products but not really understood them. When a company called SRPAdvisor, a subsidiary of Arete Consulting that offers a free database of structured products to RIAs at www.SRPAdvisor.com, offered us this column to explain them better, we agreed, figuring that some of our readers might be in the same boat.
In this post-Lehman world you cannot fail to have heard of structured products. They’re the investments that lose you money when they’re capital protected and lose you money when they’re not. Aren’t they? If the ghost of Lehman Brothers didn’t get you, the specter of reverse convertibles will?
The specter at the feast?
Language is often emotive when derivatives (and structured products are a packaged form of derivatives investment) are under discussion. They have been blamed at least in part for pretty much every market crisis and downturn since options started to nudge towards the mainstream in the 1980s, and they are still the specter at the feast according to some regulators, asset managers and many journalists.
But derivatives and structured products are just tools in the investor’s toolkit. Like any investment, they can be used or misused, good or bad value according to the part they are going to play in an overall portfolio. In their protected form they can offer investors a way to put a toe in the waters of equity, or other kinds of investments, and features such as leverage or high income options can provide less risk-averse investors with a means by which to express a solid investment view.
A structured product is a financial product that provides a pre-defined return at one or more future dates linked to one or more underlying financial prices, rates or indices. A key feature of such products is that they can be broken down into a number of separate financial instruments one of which is typically a derivative product.
What distinguishes structured products from other investments is their combination of pre-defined payoff and flexibility. If that sounds like a contradiction, it isn’t. Structured product providers can engineer the payoff of any underlying investment on which an issuing bank will quote prices so that instead of following that underlying investment one for one, some other formula determines what the payoff might be in different market circumstances.
It might go down when the market goes up; it might rise with leverage to a given point and then be capped. The point of a structured product is that this decision is part of the investment decision and has to be made upfront. The beauty of being able to make this decision is that it is at least theoretically possible to express any market view, create diversification, or provide a hedge for almost any core portfolio position.
This is the point at which detractors present their ‘but’ list: they’re opaque; they’re poor value; they’re sold not bought; they’re too complex; nobody understands them; they’re risky (because they’re ‘complex’); only the banks are getting rich; they’re just a means of laying off the positions banks don’t want on the books (another way of saying only the banks are getting rich); they’re a mis-selling scandal waiting to happen. Therefore, conclude these detractors, we not only avoid structured products, we make a religion out of it.
But many RIAs and U.S. investment professionals have already grasped that structured products are merely one more tool they can use for their investors. Sales of structured products are rising in the U.S. – with an increase of 21% in annual gross sales expected in 2010, according to our database of providers.
Banks that create products oriented at RIAs report that this is the fastest-growing segment of their structured products business in the United States. Here are just a few recent examples of conversations we have had with RIAs and other finance professionals about how they use structured products:
“Structured products are an excellent tool for use in sectors where investors cannot otherwise gain exposure, such as structured notes that reference commodities or currencies,” says Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott, of Philadelphia, Pa.
Tom Balcom, founder of Ibis Wealth Management, Boca Raton, Fla. says an ample downside buffer is the most important feature of a structured note. Balcom looks for non-correlated market access, such as a commodity or REIT index, and prefers some upside leverage with a high cap on returns. Balcom typically invests up to 35% of a portfolio in structured notes.
Scott Jurczyk, CFA principal and managing director, Chicago-based Financial Solutions Advisory Group: “...We think [structured products] should be used for principal protection. We don’t use structured notes for leveraging the upside because the leverage will be offset by the cap.”
“We look for specific payoff structures based on our macro look. We’re trying to find ways to get exposure to streams that are not correlated [to other asset classes] or offer principal protection,” says David Garff, president and founder of Accuvest Global Advisors in Walnut Creek, Calif. “If we see an idea that’s interesting, or something unusual, we’ll check it out.”
Banks like Barclays Capital have thus allocated significant resources to creating a platform that can tailor products to individual RIA needs in relatively small ticket sizes. Many of the large RIA platforms, including Schwab Institutional and Fidelity, provide some inventory of specific issuers. Also, there has been the growing presence of intermediaries like Incapital and Advisors Asset Management (AAM) moving into the RIA space. They are offering education for advisors with weekly teleconferences and seminars.
You can reach Joe Burris, head of Americas for Arete Consulting, at Joe@StructuredRetailProducts.com.
Top Executive: Jan Scibor-Kaminski
My experience as an advsior and as a business manager with structured products has not been a good one. The problems I’ve experienced are, large phantom income, illiquidity and very high imbedded structuring costs.
The derivatives/structured products groups at all firms remains the focal point because of their outsized profitability. Unfortunately it is a zero sum game.
Firms like Joe’s can be very helpful to protect you and your clients from the derivatives desks at large firms.