Investment Strategies

Advisers should think twice about structured products

They can help draw skittish clients off the sidelines, but carry risks

Nov 14, 2010 @ 12:01 am

By Jeff Benjamin

Advisers should look before they leap into structured products, an alternative-investment choice that's been gaining popularity over the past year.

Structured products, which are basically investment strategies based on derivatives that have been prepackaged by an investment bank, come in many flavors — including reverse convertibles and principal-protected notes. Depending on the product, they may offer principal protection, risk reduction in an underlying investment, enhanced returns or all of the above.

What's driving the renewed interest for such products now is that investors — still reeling from the market crash of 2008 — are looking for lower-risk alternatives. Advisers, in turn, are finding structured products a way to tempt their clients back into the markets.

“Structured products give advisers the opportunity to say something different to a client,” said Scott Miller Jr., a managing partner at Blue Bell Private Wealth Management LLC, a $300 million advisory firm.

The gist of that “different” kind of conversation is that these products are not the high-flying, risk-taking strategies that clients may think of when they hear “alternative.” Such conservatism seems a perfect fit for this market cycle, in which investors want alternatives to meat-and-potato asset classes but don't want to take on more risk.

Consider a survey of financial advisers conducted last month by InvestmentNews which found that 44% of the respondents said they have increased their clients' exposure to alternatives this year. Less than 8% of the respondents said they have decreased exposure to alternatives since the start of the year.

And yet only 22.5% of the advisers polled said their clients' appetite for risk has increased this year, while 39% said the appetite for risk has decreased and 38.5% said the appetite hasn't -changed.

Although structured products may seem the most painless way to draw skittish clients back into the market, they still carry plenty of risks. For starters, they involve highly complex strategies that can be difficult for investors to understand — a situation that is fertile ground for shady sales tactics.

Structured products also represent unsecured debt from investment banks, making them a credit risk. Two years ago, investors realized the risks of holding structured products issued by Lehman Brothers Holdings Inc. when the investment bank collapsed.

Principal-protected notes are a perfect example of a structured product that might not fit the environment. They gained popularity in the form of market-linked certificates of deposit that offer some equity market upside potential without risking loss of principal.

However, because the protection comes from Treasury bonds and the market performance comes from investing in the bond yield, now at historic lows, these products currently come with lockup periods of five years and longer.

“There's just not much left over to buy the upside, because rates are so low,” Mr. Miller said. “People always need to understand what they're giving up.”

The appetite for structured products, however, shows no sign of waning. Annual sales are up nearly 25% from last year and on pace to crack the $50 billion mark for the first time.

Reverse convertibles, for example, have gained renewed appeal as a strategy that offers downside protection while paying a regular coupon distribution, making it more attractive than lower-yielding fixed-income products.

“These kinds of investment have become so attractive because people can no longer trust stock market indexes to go up,” said Keith Styrcula, chairman of the Structured Products Association. “There's a lot of fear in the market right now, and a lot of investors don't just want one-way exposure anymore.”

According to the SPA, about 27% of commission-based registered representatives are selling structured products to their clients. More interesting, perhaps, is that 13% of fee-based advisers are using commission-free structured products.

Also of note: A separate study commissioned by the Securities Industry and Financial Markets Association found that investors with $250,000 to $1 million allocated 1.53% of their holdings to structured products, the most of any group. Investors with more than $5 million put 0.41% into the products, while those with less than $250,000 allocated 1.33%.

Questions, observations, stock tips? E-mail Jeff Benjamin at -jbenjamin@investmentnews.com.

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