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A Structured What?

What do ELKS, ASTROS, BULS, ARNs, BOXES and ComPS all have in common? They’re all part of the fledgling “structured products” boom. Wirehouses and banks are marketing them as diversification tools

What do ELKS, ASTROS, BULS, ARNs, BOXES and ComPS all have in common? They’re all part of the fledgling “structured products” boom. Wirehouses and banks are marketing them as diversification tools, another opportunity for clients to increase return while dampening risk. But so far, reception has been pretty cool from reps. The advisors that do use them like the opportunities for income and additional yield for older or wealthier clients—especially with a tepid stock market and rising interest rates—but many others say they are confusing and too expensive (loads can reach 6 percent).

So, what are they exactly? The term “structured products” refers to a broad category of hybrid financial instruments, typically a registered note, bank deposit or private placement linked to the performance of an underlying asset, whether a stock, an index, a commodity, currency or other investment. Long popular in Europe and with institutions, they’re a relatively new but fast-growing business in the U.S.

Sophisticated But Popular
According to the Structured Products Association, a New York-based trade group, in 2005 nearly $50 billion in new structured products were launched—a 57 percent increase from 2004. The New York Stock Exchange, which trades more than 575 varieties of structured products with a total value of $125 billion, this year has had 30 new listings valued at $11.2 billion, double the value of issues in the same time last year. As of year-end 2005, the American Stock Exchange was trading 373 structured products, up from 115 in 2004, with 136 new listings.

Tim Froehlich, manager of the alternative investments group at Wachovia Securities, says, “It’s a growing business here and on the Street.” Though he declined to provide specific revenue or profit numbers, Froehlich says the firm is issuing nearly 10 new structured products a month. With different underlying risk/reward formulas, depending on the goal of the investment, the products fall into one of four buckets (with occasional overlap): principal protected, enhanced growth, enhanced yield and “access,” which allows investors access to otherwise hard to reach areas like commodities or currencies.

Carmen Palladino, the director of equity structured products at Smith Barney, also says it’s a growing business for his firm. He stresses that the products are meant to diversify portfolios and should never be thought of as market-timing tools. He says the firm’s principal-protected products, called Safety First Investments, are popular with investors seeking wealth preservation but who want to maintain some market exposure, particularly older and wealthier clients or foundations. “Using a principal-protected product, say, linked to Japanese currency, if Japan goes down you get the principal back, if it goes up, you get 85 percent of the index’s return,” he says. The 15 percent the client loses from the upside is essentially the cost of insuring the principal. “To a high-net-worth client, that opportunity cost is cheap compared to losing money,” he says.

Under Scrutiny
Because of the rapid inflows of money and the relative immaturity of the marketplace, legal and compliance pitfalls are big concerns. The NASD and the SEC are both keeping close watch on the structured-products industry. Mary Ann Gadziala, associate director in the SEC’s Compliance Inspections and Examinations office, speaking in May at a Structured Products Americas conference, said: “Based on any measure, it is clear that structured finance and other derivative products are experiencing continuing significant and concentrated growth. With these developments comes increasing responsibility to manage associated risks and to ensure that these complex products are used within the confines of the law.” (Click here to read the transcript.)

Anna Pinedo, a partner at Morrison & Foerster, helps investment banks do just that, assisting with the structure of the product, as well as providing legal and compliance guidance and marketing and selling advice. “They typically have attractive interest rates associated with them,” she says, “and given the market’s performance in the past couple years, they’re another way to attain a higher yield.” But there are drawbacks, she says, including:

  • Tax confusion: “Because of the varieties of these structures, and who’s buying them—whether or not an investor is a citizen for instance—the treatment is uncertain for many of them.”
  • Fees: “They vary greatly,” she says. According to advisors, the commission can be as much as 6 percent.
  • Liquidity: Because the market is still in its adolescence, liquidity is another issue. “It’s not an active trading market,” says Pinedo, so if a client wants to sell before maturity of the issue, it could be very difficult or expensive, or both.
  • Payment flow: Even though they are generally investment grade notes, the terms are often different than a typical corporate bond. For instance, payments aren’t usually in the form of quarterly coupons. “It may only come as a lump sum at the end of the year,” she says.
  • Complexity: They can be difficult for advisors and clients to understand. “It’s important that advisors explain exactly what the client is getting, what their exposure level and risk is.”

One Smith Barney advisor acknowledges the products aren’t for everyone and says advisors who can’t explain them shouldn’t be offering them to clients. “But if I like the materials sector, say, and clients need income and some sort of downside protections, it’s a good way to go,” he says.

Others disagree. “We don’t recommend them,” says Mike Delgass, a principal with Sontag Advisory, a Westport, Conn.-based independent RIA with $3.5 billion under management. Delgass says he gets similar benefit from investing in a variety of hedge funds and growth/income mutual funds. When the market matures, he may take another look. “The retail market for these isn’t developed enough here,” he says. “Someday, there will probably be better standardization of pricing, like the annuity market has done, but until then the risk/reward analysis is difficult.”

To decide for yourself and for more information on the variety of structured products available, as well as new listings, advisors should visit the American Stock Exchange Web site or the New York Stock Exchange Web site. There are also numerous books published by large banks like UBS, ABN Amro and Societe General that delve into structured products. For a more neutral take, check out Dr. Dimitris Chorafas’ book Wealth Management: Private Banking, Investment Decisions and Structured Finance Products (Butterworth/Heinneman, 2005).

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