Research Magazine: Q & A with the SPA

By DAVID MACCHIA, WEALTH2K
ResearchMag.com

Last year structured products sales in the U.S. increased to $117 billion. And while most sales of structured products have occurred in the institutional and high-net-worth markets, the movement of structured products into the retail marketplace is clearly underway. What are the implications for competing products? According to Boston University Professor, Zvi Bodie, “The total amount of wealth that will be converted to structured products is in the trillions of dollars.”

The potential impact on other industries from the rise of structured products is one that the Structured Products Association, tackles in this interview. It’s not hard to imagine that the impact of structured products could be significant given the potent appeal of principal protection combined with investment growth potential.

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DAVID MACCHIA (davidmacchia.com): I'm most interested in exploring the whole issue of structured products, the industry and the SPA's role in it. And I'd like to start with sort of a foundational question, if I could. Which is, given the fact that in the financial services world, apart from the sector that deals with structured products regularly, I think there’s a lot of wonder and mystery about what structured products really are? Could you start at the beginning and define what structured products are?

SPA: David, it’s a privilege to be speaking with you today. Structured products are fundamentally a variation on a direct investment in a particular asset class. Equities, fixed income, commodities -- any type of traditional asset class can be the basis of a structured product. For example, a structured note linked to the S&P 500 might provide two times the upside up to a cap, or protection of your principal 100%, or the first 15% of the downside risk in the investment. Structured products may be described as enhanced ETFs – similar index exposure, but with a desirable benefit to the payoff profile that the investor values enough to pay for.

MACCHIA: The notion of delivering equity-linked returns combined with a principal protection is a concept that's I’ve written about a lot. Among others the Retirement Income Industry Association has certainly identified what we refer to as the transition management phase. Let's describe that as the period beginning roughly 10 years before retirement and continuing until 10 years after retirement. It’s becoming well understood that investment losses during this period will, at the very least, diminish for life the amount of retirement income that can be generated. Or, depending on when the investment loss occurs, potentially lead to portfolio ruin. So when I think about the benefits that structured products can provide, I become pretty excited because you can see a role for them in the lives of potentially millions of boomer clients. So what I'm describing here is the context for the migration of structured products to the retail market. Is this something that the industry is focused on? Is it a high priority? How would you describe the urgency, if there is one, to enter that marketplace?

SPA: Our belief is that we’re at the ascendancy of structured products as the pre-eminent vehicle for the massive pool of boomer retirement wealth. Interestingly enough, the U.S. lags behind the rest of the world – Europe, Asia, Australia, South America and the rest of North America for that matter -- is far behind the rest of the world in terms of principal protected exposure with guaranteed income. For Europeans, principal protected structured products are the equivalent of mutual funds to American investors. Europeans, by and large, value capital preservation over picking stocks and going for outsized returns. Americans have a different investment mentality. We believe that you can “asset allocate” risk out of your portfolio through diversification. Unfortunately, we have found that the fixed income and equities markets have a tendency to move in lockstep. The dot-com market break in 2000 proved how fallible that theory could be.

When indexes take 30, 40 and 50% hits and interest rates are so low that you get only 1 or 2% of return on your investment for a year without taking exceptional credit risk, structured products are simply the superior investment vehicle. You can repair your portfolio by selling call options in an automated structure, by purchasing high-yielding reverse convertibles.

The top 5 or 10 percent of cutting-edge investment advisors have embraced the structured products investment class and consider it to be the secret weapon that sets them apart from their competitors.

On the subject of principal protected notes, they would be a core holding in investor portfolios. But in the U.S. , there’s something of a tax disadvantage if they are held outside of retirement accounts. The Structured Products Association has engaged Congress and the Treasury on revisiting this adverse tax treatment, but in the meantime, they are optimal investments for tax-free retirement accounts.

Certain structured products that with a ten year horizon, if managed the right way, can give you more than 100% exposure to the S&P 500. It can give you more than 100% principal protection. In fact, it'll pay you a coupon of up to 1 or 2% per year at a minimum and give you full leveraged exposure to the S&P 500. As a core holding in your retirement account, it’s a very powerful value proposition for those who have that time horizon in their retirement accounts.

MACCHIA: What you're describing in terms of economic benefit seems obvious and important. And of course, John Bogle would think that investing in the S&P 500 is exciting. But what occurs to me is that because, for instance, you may think in terms of a ten-year timeframe for these products, with limited liquidity-- I'd like to come back to the liquidity issue later-- then having them in a strategic asset allocation within a retirement account framework seems to make a lot of sense. Do you agree?

SPA: David, that’s absolutely right. Advisors who haven’t made the effort to understand the new technology have inaccurately stated that structured products are “gimmicks” with “high fees.” Such thinking is a disservice to their clients and their fiduciary responsibilities to provide the client with the best possible investment allocation. To disregard structured products is potentially a disservice to the client. To be clear, not all portfolios call for structured investments, but the advisor should arrive at that decision only after a careful assessment of her client’s needs.

MACCHIA: If you accept the notion that accumulation planning is inherently different than income- generation planning, then you have to say that the majority of financial advisors in the U.S. remain in the accumulation mode mindset.

SPA: Agreed. You could say that Modern Portfolio Theory is no longer so modern, and that structured products represent the next wave of MPT.

MACCHIA: This implies, to me at least, that maybe the largest challenge the structured products industry faces is a communications challenge, in terms of recasting people's thinking about these products. Educating advisors and investors about their use in proper income distribution planning, and getting people to focus on critical benefits that they currently they don't see. Do you agree that communications is a huge issue for the structured products industry?

SPA: It's our number one priority as an industry. And I think you touched upon a very important point – it’s not simply education of the brokers and advisors on the utility of structured investments, it's more about winning over hearts and minds. I’m going to be a bit controversial here: a good number of brokers and advisors have been intellectually lazy about learning about the investment class and have resorted to denigrating the investment class to the clients by saying, "Oh, it's too high fee, too high risk, too complicated for you. So I’m going to do you a favor and steer you away from that.”

Some advisors sell their own portfolio management skills by selling against structured investments. As an industry, we have our work cut out for us. And I spend a lot of time with the chief investment officers of the major wealth management firms advocating for this investment class, telling CIOs they should have structured products available to their top producers. So it's a top-to-bottom/bottom-to-top education challenge before us.

For the full interview in Research Magazine, click here.