Structured products I

Structured Products I
In my September 30, 2007 Hot Off the Web, I mentioned John Authers of the Financial Times in “Structured vehicles may be way forward” discussing how, in the wake of the relatively poor recent performance of hedge funds and private equity, the emphasis may be shifting away from hedging to guarantees in the wealth management business. He predicts a boom in structured products that promise to protect the downside (guarantees) yet allow you to participate in the upside.
What are Structured Products?
In simplest terms, structured products are combination of a fixed income portion, which together with interest earned to maturity secure the guarantee, and some kind of derivative component which offers the opportunity to track the performance of an index, a commodity, currency, etc or combinations thereof. There are other mechanisms to implement the principal protection, like puts and collars, or constant proportion portfolio insurance (CPPI); a quick overview is provided by Kochis Fitz Market Perspectives on Structured Products. The guarantee (or principal protection) is as good as the credit rating of the issuer, and can be complete or partial. The behaviour of the structured product can be customized to achieve specific objectives of an individual investor or it can be a pre-packaged “mass market” retail product. You can get more background information at a number of websites like Structured Products or Morgan Stanley , or Investment Advisors’s “Structured Products on the Rise” or Investopedia.
But what is really different about structured products is their specified maturity date, often offer full or partial principal protection, and they are targeted to investors with specific market views (positive, negative, sideways) and risk tolerance (e.g. prepared to take less than 100% of the returns that the markets offer in exchange of some principal protection). Structured products have substantially different risk- return profiles from traditional investments (like stocks, bonds, GIC/CDs).
Commonly stated objectives of structured products include: (1) principal protection (full, partial or may even be unprotected)
(2) enhanced performance (yield-e.g.subprime mortgage SIVs, (enhanced) return of an index, leverage, etc) (3) access to otherwise difficult to access asset classes (commodities, currencies, etc) (4) tax minimization /efficiency (e.g. see “IRS probes tax goal of derivatives” )
Structured Product Considerations
First let’s consider the guarantee. For example consider the value of the guarantee on a five year maturity product; in effect getting back your principal after five year deprived you of the opportunity to earn five years of GIC/CD income plus you lost the purchasing power due to inflation. So if you live in 5% interest and 2.5% inflation world, you would still have lost about 30% of your purchasing power with the guarantee. And, of course the guarantee is only as good as the issuer’s ability/willingness to pay.
Lack of liquidity is another consideration. Structured products typically don’t pay dividends or interest prior to maturity; so there is no cash-flow prior to maturity. Issuer may redeem product with a (significant) penalty and there may or may not be a secondary market during the holding period; when a secondary market is available, volume can be expected to be low and the spread much larger than for the underlying securities/indexes being tracked.
Participation rate in an equity index’s growth, which could be at 80%, 100% or 150%, but it usually excludes the returns associated with dividends during the holding period (this, even in the current low dividend world that we are living in, can amount to about 2% per year).
Access to otherwise difficult to access asset classes is to my mind the only relatively easily justifiable objective for structured products. Access to commodities would otherwise be difficult or impossible for the average investor. For example Barclays iPath ETNs.
Asset allocation is another consideration. You cannot look at structured products on a stand-alone basis; you must consider it as part of the overall portfolio’s target asset allocation. But what asset class are the structured products? Often due to their complex structure and significantly different risk-return characteristics, these products may create difficulties in terms of classical approach to asset allocation.
Taxation is an even more complex consideration. Depending on the structured product and the issuer’s opinion of its likely tax status, in the U.S. the returns may be treated as income , capital gain (Barclays ETNs) or are being challenged by the IRS as to their tax status (if they deem that the product was created for tax reasons only, and has no other economic value). For Canada, I have found no information about the tax treatment (though related derivative transactions appear to be treated as capital gains/losses).
Cost is another significant consideration. There are many aspects of cost underlying a structured product: transaction costs, option costs (puts for downside protection, calls for index participation), loss of dividends, capped upside, and of course the fees associated with the product. In principle, the objectives associated with structured products a meritorious; however their usually high cost (at least to retail investor) and the difficulty of understanding the actual cost is a significant obstacle.
Transparency/complexity is the final consideration that makes it very difficult to recommend structured products to a retail investor. As the saying goes, there is no free lunch. One of the instances when investors use SPs is when they have a “view” (they feel that there is an above average probability that market will drop “significantly” or they expect that the S&P500 will move up significantly and they want a leveraged bet on that). The “view” is based on a prediction/forecast that may or may not happen, but the costs associated with the product are guaranteed to be deducted from the investor’s assets.
A very interesting analysis of structured products is McCann and Dengpan Luo’s “Are structured products suitable for retail investors?”. Their conclusions are:
“Equity-linked notes are complex, opaque and expensive – and the more complex and opaque they are, the more expensive they are. Even with the best disclosure materials and the most thoroughly trained and supervised registered representatives, it is unlikely that retail investors can understand the risk-return tradeoff and the costs being incurred in some of the complex equity-linked notes and structured products currently being marketed.
Moreover, we find simple portfolios of stocks and bonds can be purchased and periodically rebalanced which will yield more wealth at maturity than an investment in any of the three equity-linked notes we have analyzed at issuance whatever the level of the S&P 500 or whatever the stock price. These products add nothing to retail investors’ portfolios that can’t be acquired from investments “already available in the market in the form of less risky, less complicated, or less costly products” and therefore fail the “reasonable-basis” suitability requirement for sale to retail investors.”
There is more experience with this type of product in Europe where the retail market for structured products has been around a lot longer than in North America. In fact there was a Financial times article “Structured products: there is no such thing as a free lunch”  by Sarah Ross in April 2005 analysing the tradeoffs associated with structured products. She indicates that “Robert Lockie, a certified financial planner at Bloomsbury Financial Planning, says he has problems with structured products’ lack of transparency, counterparty risks, frequent tax-inefficiency, and lack of dividends. He believes they have a fundamental flaw in that, due to their fixed term, investors cannot rebalance their portfolio’s asset allocation in order to control its level of risk. If an investor does choose to withdraw his or her capital before the term of the structured product, they are likely to face steep penalties.”
In summary, if you don’t understand it, don’t buy it! I have not yet seen compelling evidence for the use of structured products available to the average investor except to access otherwise inaccessible asset classes, like commodities
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