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A Tempest Over Structured Products

STRUCTURED PRODUCTS, complicated hybrid securities used both to hedge and to speculate, are among the fastest growing investment vehicles in the retail market

STRUCTURED PRODUCTS, complicated hybrid securities used both to hedge and to speculate, are among the fastest growing investment vehicles in the retail market, according to their backers. Last year, sales of the antiseptically named securities were estimated to have leapt to $64 billion overall, a 33 percent increase. Approximately 50 percent of 2006 sales were driven by retail financial advisors and their clients.

“The general trend is that structured products are moving towards the retail market,” says Keith Styrcula, founder of the Structure Products Association (SPA), a four-year-old industry trade group.

Yet, structured products — a broad range of new investment products that combine two or more financial instruments (one of which is a derivative) — are among the more controversial securities to trickle down to the retail set. Indeed, many sophisticated financial advisors swear by the products, citing their ability to hedge exposure to, say, the stock market — but many other FAs just swear at them. And, regulators stipulate that only the most sophisticated retail investor should be exposed to them.

Perhaps that is inevitable. Until the mid-1990s, structured products were only available to the ultra-high-net-worth at a handful of private banking institutions, according to the SPA. Today, there are more than 30 manufacturers of the products, and hundreds of brokerage firms offer them to clients under various proprietary acronyms, says Styrcula. Other firms, like Linsco/Private Ledger (LPL), Schwab and Fidelity have opened their RIA platforms to structured products. They are trading on secondary markets, such as the NYSE, AMEX and Nasdaq, and they are growing fast; the NYSE in particular saw listings jump 50 percent in 2006, to 64, with a value of $30 billion.

Despite the surge in popularity, many advisors still don't know what structured products are supposed to do. And even some of those who do don't like them. They have good reasons: They are complex (often too difficult to explain to clients), expensive (it can cost as much as a 3 percent charge to the investor when the investment bank's underwriting fee and broker's commission are tallied) and illiquid. Even regulators are examining how they are being presented and sold. A former SEC economist has issued a research report calling the securities an outright rip-off: mediocre results for inflated fees (it's a report that has most structured securities' advocates groaning).

But fans of the products say that pricing is improving rapidly and that, with a little homework and research, benefits like principal protection, superior risk-adjusted returns and access to hard-to-reach investment sectors are too good to pass up for some clients.

Scott Miller, a financial advisor at Blue Bell Private Wealth Management, a fee-only RIA in Blue Bell, Pa., with $250 million under management, is a frequent user. He says that nearly 30 percent of Blue Bell's $250 million in client assets is in structured products. Miller uses the securities to hedge. He says clients are mostly older, conservative types who want their ample nest eggs protected, not gambled. Miller likes digging for value and would hardly waste his clients' money for a fad, he adds. He says clients understand what he's doing and why, because he holds weekly and monthly meetings.

Complicated — But Useful — Stuff

But just what is it? An NASD podcast on the subject defines a structured product as a “nontraditional security whose value is based on the performance of other securities.” They generally have two parts: a note and a derivative, which usually combines elements of stocks, bonds and options. The note typically pays interest to the investor at a specified rate and time interval, and the derivative (typically an index, commodity, stock or bond) pays the investor upon maturity of the note. In addition, different types of notes carry differing levels of risk (full, partial or no principal protection) combined with a reward (returns can be less than, equal to or multiples of the underlying investment's return, to a preset limit).

Miller is not alone in his ardor for structured products. Indeed, the variety of risk-and-reward features they offer is intriguing to many advisors. Mark Soehn and Scot Jurczyk, of Financial Solutions Advisory Group, a fee-only RIA in Chicago, use structured products as part of their growing allocation to alternative investments. “We like them for diversification purposes and the fact that they offer better yields than money markets or bonds, but with less risk than equities,” says Jurczyk. He says a typical client portfolio has 20 percent of its assets in alternatives, with no more than 5 percent of that in structured products, most of which offer full or partial principal protection. Since his average client has $2 million to $3 million in liquid assets, preservation of principal is paramount. But he's not looking to lose either: “There's nothing wrong with bonds, but if I can beat the bond without the risk of the equity, I'm going to do that,” he says.

An example of a principal-protected note Jurczyk says he's used in the past is one that is linked to three indexes: the S&P 500, the Euro 50 and the Nikkei 225 indexes. “What the client gives up is the dividend yield on those indexes, but since it's in exchange for principal protection, we think it's worth it,” he says. He also uses so-called reverse convertible notes, which are linked to a stock or a basket of stocks and offer some downside protection — say 20 percent to 40 percent — but also put a cap on the upside. “If the stock goes up 100 percent, I'll get 14 percent or around that,” he says, “and if it tanks, I have a buffer.”

That “buffer” sounds expensive to some. “In the past the upside caps have been too low for the cost,” says one Smith Barney rep, who says if he feels strongly about the direction of the market's future, he simply structures stock-and-bond portfolios to reflect that forecast.

Other gripes against structured products include: the confusing sea of acronyms each company uses for its own products; the loss of any dividends from the underlying assets; inferior liquidity due to a thinly traded secondary market; tax inefficiencies (returns on principal-protected notes are treated as ordinary income, not long-term gains); and inadequate fee and cost disclosure.

Blue Bell's Miller acknowledges the criticisms, but says he and his team can overcome most of them. “Skeptics of structured products have good reason to be that way — they still charge too much,” he says. To get lower prices, Miller doesn't buy new issues from the brokerage firms; instead he goes directly to the manufacturers, tells them what type of product structure and return he's looking for and then picks the best offer. (In essence he's avoiding the middleman.)

And then there's Miller's diversification strategy: Not only does he use many different banks, he uses a variety of indices (as many as eight may be in a client's portfolio), as well as types of notes and different maturity dates (for a bond-laddering effect) so that he achieves diversification across multiple factors. He tends to agree with the roughly 8 percent return predictions many economists are making for the coming years in the stock market. “But if you like the market and think it will go up more than 17 percent, you're probably better off in an ETF,” he says.

Or, as a study published in December 2006 concluded, you may be better off in a comparable stock-and-bond portfolio. The study, entitled, Are Structured Products Suitable for Retail Investors?, was written by Craig McCann and Dengpan Luo, president and vice president, respectively, of the Securities Litigation and Consulting Group (SLCG) in Fairfax, Va. SLCG is a financial economics consulting firm that also provides expert witness testimony to individuals and institutions involved in securities-related litigation. Both men are CFAs, have PhDs in economics and lengthy resumes (McCann was an economist at the SEC). The study is a damning evaluation of the structured-product industry. They examined only one type of structured product — equity-linked notes — but they insist the findings can be “readily extended” to the other types as well.

Survey Says

Specifically, the study looked at three notes with different features and terms from three different firms: Merrill Lynch's S&P-linked, principal-protected MITT; JPMorgan's S&P-linked, principal-protected Capped Observation Notes; and Citigroup's Intel-linked, enhanced-yield TARGETS. What did they find? Comparable portfolios of stocks and bonds — without rebalancing — were found to outperform each of the three notes between 94 percent and 97 percent of the time. “At best, structured products, specifically the ones we looked at, replicate returns you could get from other securities,” says McCann. “But without the liquidity or transparency.” The study concludes that they are unfit for sale to retail investors “even with the best disclosure materials and the most thoroughly trained registered representatives.”

Many advisors agree. One advisor at UBS with roughly $1 billion in assets under management says the firms have merely hooked into another revenue stream. “It's the new thing, and Wall Street loves new things because sales are hot and the competition isn't there yet,” he says. He calls structured products permutations of futures and options that don't add anything for the client. “After the firm pays me my 1 percent, pays itself 1 percent to 1.5 percent, the return to the client is the market rate minus costs,” he says.

Yes, it's true structured products are a new, high-margin revenue source for broker/dealers and investment banks, but “with the bigger market and more competition, there has been fee compression in our industry, too,” says the SPA's Styrcula.

Miller agrees and also thinks the market is maturing. “The idea of the lack of liquidity is a bit overdone,” he says. “Every bank makes a market, there are bids and asks and the spread between all the banks is about 1 percent with all the quotes published every day.” That said, he says advisors interested in the products still need to do a lot of homework and research. To that end, Miller's team has created roughly 25 models of a variety of structured products that they refer back to when looking for value in a prospective product for clients. “Once you see three or four of these things you can understand them and know what to look for,” he says.

And sifting through the different products will get easier in the future. In December, JPMorgan proposed to the SPA an industry standard for structured products “that would increase transparency, alleviate investor confusion and facilitate easier comparison among various investments,” according to the release. Some firms, like UBS and JPMorgan, are now selling other firm's products. “Embracing open architecture will be key for further growth,” says Styrcula.

And improvements are welcome, especially from the NASD and the SEC, whose officials have singled out the structured-product market in recent months as being under watch. The NASD has issued marketing and supervisory guidance to firms and is offering online educational seminars about structured products. The self-regulator has also warned firms and advisors to “limit the availability of structured products to clients whose accounts are approved for options trading.” Some advisors don't need to be warned. Eric Park, of Steamboat Financial Group, an LPL affiliate in Washington, Mo., says he'll be taking a pass for a while: “I think what you'll see is that structured products, with a bit more competition and a lot more sunshine, will become more viable and less costly, or eventually go away — until then I'd rather keep my money and see what happens.”



  • Full or partial protection of principal
  • Can be used to hedge or speculate
  • Can provide access to hard-to-reach asset classes
  • Ability to custom tailor an investment structure


  • Confusing array of names and product choices
  • Difficult to understand investment characteristics
  • Liquidity inferior to, say, ETFs
  • Popular principal-protected notes are taxed as ordinary income
  • Fees can be high
  • Upside returns are capped
  • No dividends from underlying investments
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