high net worth, structured products are attracting mass affluent
investors as well these days as they have been unbundled from other
alternative investment product suites. Charles
Davis reports.
The big US banks have caught on to the structured products boom and
while these products remain but a fraction of their overall
business, sales are expected to soar as the powerful broker/dealer
firms jump on board.
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Last year, American investors purchased $64.3 billion in structured
products, up 32 percent from $48.7 billion in 2005, and issuance is
expected to hit $100 billion in the US this year, according to the
Structured Products Association (SPA) in New York (see chart).
About 50 percent of 2006 structured products sales came from retail
financial advisors and their clients, evidence that the broader
investment market shares the enthusiasm of the high net worth
set.
Large distributors are coming into the structured products market
for the first time, as Fidelity, Schwab, Northern Trust and Nuveen
have all set up new divisions in the past year or so. According to
Greenwich Associates, more than 80 percent of the 39 largest US
broker/dealers currently offer structured products to customers.
Greenwich’s survey found that nearly 90 percent of the top
broker/dealers expect demand for structured products to increase
over the next 12 to 14 months.
While some products have been virtually mass produced for the mass
affluent, the part of the market attracting most attention is the
HNW market, where products are created to satisfy the particular
needs of particular clients. Broadly speaking, these investors fit
into two categories: either they want to reduce risk or they want
to increase it. Structured products can cover both these
requirements.
In general, the market for structured products has evolved very
rapidly over the past two years, moving away from simple fixed
income or equity funds to offer an entire suite of products. Many
clients look to allocate between 10 percent and 20 percent of their
portfolios to hedge funds/private equity, and another 5 percent to
10 percent to commodities or alternative strategies.
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By GlobalDataStructured products typically combine derivatives – some form of
options and futures – with equities or fixed-income securities to
achieve a specific market exposure, sometimes with a limited
downside risk or upside potential. Most have fixed maturities of at
least three years and are sold directly by issuers to institutions
and HNW individuals, or through third-party distributors.
Structured products have evolved along with changes in the interest
rate backdrop. As short-term rates trend higher and the yield curve
remains flat, investors seek higher returns and shorter timelines.
The catch in enhanced return structured products, for example, is
that potential profits are capped. Also, the investor will not
participate in any dividends provided by the underlying index,
since these products are structured through the use of
derivatives.
Until the mid-1990s, structured products were only available to the
ultra HNW 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. Other firms, such as
Linsco/Private Ledger, Schwab and Fidelity, have opened their
platforms to structured products. They are trading on secondary
markets, such as the New York Stock Exchange, American Stock
Exchange and the NASDAQ, and they are growing quickly; the NYSE, in
particular, saw listings jump 50 percent in 2006, to 64, with a
value of $30 billion.
Structured products have grown in popularity because of their
flexibility. They can be used as an alternative to a direct
investment or as a part of the asset allocation process to reduce
risk exposure of a portfolio or to leverage a bullish market trend
without taking the downside risk, since the capital is protected in
most cases.
Despite the surge in popularity, many advisers still don’t know
what structured products are supposed to do. And some of those who
do know don’t like them. They have good reasons: the products are
complex and often too difficult to explain to clients; and they are
expensive, as 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.
Supporters of the products say that pricing is improving rapidly
and that, with a little homework, benefits such as principal
protection, superior risk-adjusted returns and access to
hard-to-reach investment sectors are too good to pass up for some
clients.
They remain accessible largely to only the HNW: a worthwhile
investment still requires a hefty $500,000, according to the SPA.
But investors can get deals for as little as $5,000, or $2,000 for
investment retirement accounts, from distributors.
Derivatives play
Structured products 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).
A structured product uses derivatives to add or remove risk from
some asset, which can be anything from a stock to a market index,
from commodities to currencies. Typically, structured products
combine some degree of downside protection with a large dose of
upside potential, but the risk-controlling elements of structured
products are their defining characteristic. Derivatives can help
investors manage that risk-either by dialling it up or down as the
market fluctuates – a great selling point in these uncertain
times.
Less risk-averse investors can invest in products that offer
multiples on index returns up to a set maximum, offset by reduced
principal protection. Riskiest, but offering guaranteed yields of
some 20 percent, are reverse convertibles, which are a bet on the
performance of a single stock.
US structured products experts need only look to Europe for proof
of the potential for further growth, where 2006 issuance reached
$193.6 billion. And Europe’s structured products business pales in
comparison to Asia. According to the latest wealth survey by the
Boston Consulting Group, the wealthy in the Asia-Pacific region
have allocated as much as 8 percent of their portfolios to
structured products, compared to the global average of 3 percent.
This could total some $600 billion.
Swaps and options
The big traditional stock markets still dominate structured
products, and many investors continue to pick small baskets of
stocks where they have a directional view. But here, too,
investment patterns are changing, with structured products offering
investors themed baskets with a clear story, as well as highly
sophisticated swap and option strategies that only big trading
desks can execute.
In today’s jittery equities climate, products such as principal
protected notes (PPNs) are ideal for investors who want exposure to
equities without risking any principal. PPNs typically have up to
five-year maturities and offer investors 100 percent principal
protection and 100 percent participation on the upside, and can
even include a guaranteed minimum gain. Structured products cost on
average 25 basis points in the US, a relatively inexpensive product
for a short-term product with built-in principal protection.
Another structured product, enhanced yield notes, offer investors
with more appetite for risk than the typical annuity buyer more
upside potential at the cost of some downside protection. Many
variations on enhanced yield notes offer a wide variety of downside
protection options: contingent liability notes, for example,
provide a barrier on the downside for slightly accelerated,
unlimited upside.
Yet another structure is a note with a covered call at its heart. A
covered call involves selling a call option linked to a security
that the client already owns. Selling a call earns the investor a
premium that enhances the total return, particularly if the stock
earns a dividend as well.
Private bankers report burgeoning interest in structured products,
usually sold as notes with embedded derivatives linked to virtually
any instrument that one can think of – currencies, gold, equity
indices and individual stocks are a few. Some of these structures
are making their way to the retail market as unit trusts, albeit to
what appears to be a lukewarm reception so far.
Private clients, however, have the clout to get products tailored
to their specific needs, a factor that helps to drive demand.
What’s more, for simpler structures, minimum investment sums have
fallen significantly, bankers report.
Many structured products for HNW individuals had a focus on
emerging markets equities during 2005 and 2006, as Brazil, Russia,
India and China generated high returns for investors.
Now private banking clients are looking beyond developing markets
for new opportunities, and private equity is gaining popularity as
an area where private banking clients are using structured products
to gain exposure to top fund managers and their strategies.
Dollar bets
HNW clients in the US are also turning to reverse convertibles,
also known as revertibles, which are effectively high-dollar bets
on a single stock. Revertibles caught on around 2000 when the
dotcom bust gutted the stock market and interest rates hit historic
lows. Investors were starved for yield and the stock market was
flat.
With a revertible, an investor gives up any appreciation in the
stock’s value, but instead receives a big guaranteed annual coupon.
There is some downside protection, but if the stock drops below the
protected level, the investor must buy the discounted stock at the
original higher price.
For example, say a stock is trading at $100 a share, and the client
buys a $1,000 revertible on it that pays 20 percent a year with
downside protection of 20 percent. As long as the stock’s share
price does not drop more than 20 percent (or $80 per share), the
investor gets their money back plus 20 percent interest
($1,200).
Of course, the downside is that if the stock’s price drops to $70
at maturity, the investor has to buy the shares from the investment
bank at a premium of $100 apiece. The investor owes the bank $1,000
for $700 worth of stock, but because the investor still gets the 20
percent in interest ($200), the loss is offset by that amount. The
investment bank keeps the $100 left over from the initial $1,000
investment.
It’s a risky play, but blue-chip stock revertibles with high-yield
returns have attracted a lot of private banking clients. Most are
structured as a three-, six- or 12-month maturity, with interest
rates of 8 percent to 20 percent, which are paid to the investor
quarterly or semi-annually.
Such personal attention does not come cheaply, but intense
competition across the structured products market means that prices
have come down significantly in recent years. At the same time,
transparency has increased, so, even though these products do not
carry explicit fees, clients can compare pricing on offer from
different firms.
While structured products have some advantages of annuities,
equities and bonds, they are not perfect. In addition to the risks,
there is no liquidity; the money is tied up. It also can be
difficult for advisers to understand how returns are calculated,
especially when compared to the point-to-point projections offered
by annuities and other longer-term products.
Structured products are not for everyone. Typically, they are a
means to express an investment view, whether bullish, bearish or
range-bound.
However, by laddering structured products over time, advisers can
help dilute the risk, building a portfolio of structured products
and using dollar-cost-average strategies to time investments. The
difference is that structured products have the potential to
provide much higher returns within the same time frame.
All market participants believe that this segment of the market
will continue to expand over the next few years, moving into new
parts of the world and covering an increasingly wide variety of
asset classes. Whether the US market will approach European or
Asian volume remains to be seen, but all signs point to rapid
growth for the foreseeable future.
