Investopedia: Structured Retail Products Too Good To Be True?

by George D. Lambert
(Contact Author Biography)

Structured retail products promise a return tied to a portfolio's earnings and guarantee you'll get your original investment back - regardless of what happens to the market! And some even offer to pay double or triple an index's return. You might wonder whether there's a catch. Can there really be reward without risk? It would seem so - that is, until you look beneath the surface.

The financial institutions issuing structured retail products might invest in one or more stock indexes. For instance, these could include the DJIA, the S&P MidCap 400 Index, the S&P SmallCap 600 Index, the Dow Jones EURO STOXX 50 Index, or the Nikkei 225 Index. Some even offer products that are tied to a handful of stocks in one industry, such as the energy sector.

Who sells them? Several banks and brokerage firms offer structured retail products, each with a unique acronym, but the concepts are basically the same: If the underlying index or stock in the portfolio does well, you'll get a piece of the return. On the other hand, if the market tanks, you're assured to get all of your money back. Plus, they might throw in a little interest.

How They Work

One bank, for example, has a $1,000 five-year note that pays at maturity the greater of two amounts:

Your principal plus a 5% total return (0.98% annual), which comes out to: $1,050

A piece of the underlying portfolio's or index's return. The payout includes dividends, but it's credited quarterly and your account is charged for any losses in the index. At the end of each quarter, you'll get credit by calculating the:

Ending Level - Starting Level
______________________
Starting Level

Then, the level is reset for the following quarter. Your total return is the compounded value of the 20 (five years x four quarters) quarterly returns. The most you can make with this particular bank's product is 7% per quarter.

Compounded, that comes out to 31% a year - not too shabby. But what if the market doesn't go up every quarter during the year?

[Theoretically assume] the market had a 6.59% gain for the year. However, because of the way the earnings were credited with this bank's structured retail product, you would have actually lost 7.55%! You wouldn't have this problem, though, if the market stayed on a steady, upward course throughout the year.

How does the issuer protect your capital?

Since the financial institution promises to return your principal, it has to hedge against a drop in the underlying index. As a hypothetical example, imagine you invest $1,000 in a three-year structured retail product that is linked to the DJIA. The institution might put $865 of your money into a three-year zero-coupon bond that is set to grow to $1,000 at maturity. Therefore, if the index drops in value, the institution has the money to meet its obligation to you. Next, the institution uses the remaining $135 to buy call options on the DJIA. That way if the index rises, it'll get both the initial principal ($1,000) and profits related to the index's growth to share with you. But if the index falls, the call options will not be exercised and the investor will still have his initial $1,000.

Other Versions

There are products out there that have different payout caps, such as 90% of the S&P 500's return. You might also run across structured retail products that offer to pay a return at maturity that is a multiple of their underlying market index's return. However, the gains might be subject to limits, such as no more than a 30% total gain over two years, so don't expect to make a killing.

Furthermore, you might have to share in a portion of any decline in the index; therefore, you could get back less than your initial investment. (To read more about capital gains, see Capital Gains Tax Cuts For Middle Income Investors and A Long-Term Mindset Meets Dreaded Capital-Gains Tax.)

How They're Taxed

The tax rules for structured retail products are similar to those of zero-coupon bonds. Therefore, even though you don't actually receive the guaranteed interest each year, you'll pay annual tax on it at your ordinary tax rate (up to 35% federal). At maturity, if the account is up, you'll get another tax bill on the additional earnings.The RisksStructured retail products carry a few risks. Among them:

Neither the FDIC, nor any other government agency, guarantees the products, regardless of whether you bought them from your bank. They are unsecured obligations of the issuing financial institution. As a result, if the issuer goes down the tubes, your investment could, too.

Structured retail products are not redeemable prior to the maturity date. You can try to sell on the open market, but the price you get may be influenced by many factors, such as interest rates, volatility and the current level of the index. As a result, you might end up with a loss.

You won't receive any interest while you own the account.

Conclusion

Structured retail products are a little like certificates of deposit tied to stocks - you get some upside potential with a safety net in case the market takes a dive. Plus, whenever interest rates rise, the minimum promised returns might be an attractive alternative to traditional fixed-income investments, such as bonds. Nevertheless, there are restrictions, so make sure you understand the prospectus before you invest. Otherwise, you could be horrified to suddenly discover that you own an investment that goes down in an up market, and that you may not be able to sell it without taking a loss.

by George D. Lambert, (Contact Author Biography)

George D. Lambert is a freelance financial writer with more than 20 years of experience in the financial services industry. He has worked as a Certified Financial Planner, a Certified Divorce Financial Analyst and an arbitrator for the NASD, NYSE and AAA. George is approved by the Florida Licensing Education Section to instruct life, health and variable annuity courses. To read more about George and his services, visit www.e-financialWriter.com. Also be sure to check out his latest book, "A Boomer's Guide To Long-Term Care".

NASDAQ-SPA June 11 Meet-the-Press Event at NYC MarketSite

Panel members from the Second Annual NASDAQ-SPA Media Event on June 11, 2008 (left to right): Matt Ginsburg, Wells Fargo; Keith Styrcula, Structured Products Association; Karen Fang, Goldman Sachs; Philippe el-Asmar, Barclays Capital; Scott Mitchell, JPMorgan; John Radtke, InCapital; and Richard Keary, NASDAQ-OMX.

Special thanks to NASDAQ's Wayne Lee for the press availability. Photo by Rob Tannenbaum.

Structured Products Confused with CDOs - Investment News

By Dan Jamieson, June 11, 2008

NEW YORK - Sales of structured products continue to grow despite the fact that they are often confused with subprime-tainted collateralized debt obligations, said Keith Styrcula, chairman of the Structured Products Association at a media briefing today in New York.

“Half of all news alerts talk about CDOs as structured products,” he said. “They're not CDOs; they're not subprime.”

Ratings agencies have added to the confusion by calling some of their CDO-ratings groups “structured-products groups,” Mr. Styrcula said.

The confusion has also caused some compliance officers at brokerage firms to wonder whether investors are being sold mortgage-backed bonds, he said in an interview.

Sales of structured products are expected to reach $120 billion this year, surpassing the record $114 billion in sales in 2007, according to the Structured Products Association.

In 2006, sales were just $64 billion.

Retail buyers have been increasingly interested in products with downside protection and strong credit ratings, according to industry participants on a panel at the briefing.

About 16% of sales this year have been in commodity-linked products, up from 8% last year, said Philippe El-Asmar, managing director and head of structured-product sales at Barclays Capital, the New York-based investment-banking division of London-based Barclays Bank PLC.

To see the original version of the article, click here.

The Fever for Structured Products -- Registered Rep.

By BRIAN WARGO, Registered Rep. Magazine
(Originally published March 1, 2008)

Long a Favorite of Investors in Europe, structured products are rapidly gaining popularity in the United States. Last year, $114 billion in structured products were issued in the U.S., according to the Structured Products Association.

That's a 78 percent jump over 2006 — and dwarfs the $32 billion in structured products issued in 2004. Previously the sole purview of sophisticated high-net-worth investors in the U.S., they have begun filtering into the mainstream. The retail market bought some $58 billion — or about half — of the structured products issued in 2007.

Structured products combine financial instruments, typically bonds and derivatives, into a package that allows investors to bet on the direction of stocks, bonds and other investments. They are used to both hedge and to speculate, and typically pay an interest or coupon rate substantially above the prevailing market rate. Many of them also cap or limit upside returns, particularly if principal protection is offered.

One reason demand has picked up so much over the last three years is that a number of new financial institutions have entered the market, says Kumar Doraiswami, managing director and head of sales for Natixis Capital Markets. There are 30 active issuers today, up from 10 five years ago.

That has improved liquidity and helped to cut transaction costs — two issues that have long concerned investors and advisors, he says. The increased number of offerings, and the accompanying press coverage, has also helped generate greater awareness of the benefits and risks of the (relatively new) instruments, says Philippe El-Asmar, managing director and head of investor solutions for the Americas region for Barclays Capital.

El-Asmar believes structured products will continue to win greater appeal, particularly those that give investors exposure to attractive but risky markets, such as emerging equities or commodities, but protect them on the downside. Those frustrated with a 3.5-percent return on bonds, for example, may appreciate a product that protects their principal while giving them 80 percent of the upside in the market, he says.

Current market conditions could also enhance their appeal. Randy Pegg, executive vice president of Colorado-based Fixed Income Securities (FIS), says the U.S. structured-product industry witnessed tremendous growth during the market correction of 2000 to 2001 as more investors realized they could protect their downside, yet remain invested for some upside.

The same reasoning may now be at play, according to Pegg. “We have experienced increased demand with the recent market sell-off,” he says. “Investors have learned that to make money in the market, you must be in for the up days. When they know they have principal protection, investors can stay invested longer and still sleep at night — especially during turbulent times.”

For the full article, please click here.

State Street Survey: 60% of Pros Know ETNs

Advisors name ETFs as most innovative investment vehicle of the last two decades -- Products have become an increasingly vital investment vehicle
Tuesday, June 10, 2008
By James Langton, Investment Executive Magazine

Exchange-traded funds (ETFs) are changing the financial advisory business, according to new research from State Street Global Advisors and Knowledge@Wharton, the online business journal of The Wharton School at the University of Pennsylvania. The survey of 840 investment professionals found that 67% identified ETFs as the most innovative investment vehicle of the last two decades, and 60% reported that ETFs have fundamentally changed the way they construct investment portfolios.

Also, 76% of advisors believe the use of ETFs encourages fee-based models; 76% identified themselves as light-to-moderate users of ETFs, indicating that less than 50% of their portfolios utilize ETFs, just 4% report they do not use the instruments at all; 60% of respondents said they knew what exchange traded notes are, and 29% indicated that they plan on increasing their use of ETFs in the future; only 31% of advisors are currently using inverse ETFs, which allow investors to bet against a market index. However, nearly 40% report that they plan to increase their use of inverse ETFs in the future.

Advisors identified the top five most appealing characteristics of ETFs, as: low cost, liquidity, intra-day trading capability, tax efficiency, and investment style purity. The greatest disadvantages of ETFs were identified as: “unknown/untested indexes and/or portfolio methodologies” or the, “overwhelming number of choices.”

“Exchange traded products have become an increasingly vital investment vehicle for financial intermediaries,” says Anthony Rochte, senior managing director of State Street Global Advisors.

“By incorporating exchange-traded products into sector rotation, core-satellite, tax management, and portfolio completion strategies, advisors are simultaneously managing costs and risk, which helps underscore their value proposition and strengthen relationships with clients.”

“The pace at which new ETFs and indices are entering the market is clearly a concern,” said Rochte. “In light of these findings and the increasing importance of understanding index methodologies, the role of responsible product development and educational support cannot be overstated.”

Robert Spicer: Market-Linked CDs

"Only thing we have to fear is fear itself". Franklin D. Roosevelt, March 4th, 1933

FDR gave this famous quote during his inaugural speech. Many people today erroneously believe he was talking about the threat of WWII. Not true. He was talking about the economy of the United States of America and the financial crisis it was facing at the time. Banks were particularly hard hit. Confidence was so shaken that a rumor could create a run on a banks assets and it could be closed overnight. However, by innovative and somewhat dramatic actions he regained the confidence of the American people in the U.S. banking system. One such step was the Nationwide Bank Holiday, closing every bank in America for an entire week. Every U.S. bank, while closed, was inspected by government examiners who would only open the bank if it was given a sound fiscal bill of health by the US Government.

This type of American ingenuity and will power changed the fabric of our financial system and allowed the United States to become the financial powerhouse it has become. Yet, today, our current stock market volatility and credit crunch has again created overblown fear. A fear that may be self defeating in the long run.

The world’s largest banks have devised a way for most investors to participate in the appreciation of the equity markets while protecting the principal invested with FDIC insurance.

Even the most conservative of investors now have the ability to participate in most, if not all, of the upside potential of a variety of markets (such as the S&P 500, DJIA or a basket of stocks or commodities) without the risk of losing any principal provided the investment is held to maturity. Typical maturities range from one year to seven years. Participation rates on the upside vary with each issue and can reach 100%.

These investments are called structured Certificates of Deposit or Market Linked CD’s. They are issued by some of the largest banks in the world and linked to indices or investments. The investor’s principal is protected (insured) up to $100,000 per depositor or up to $250,000 for certain qualified retirement plans such as an IRA account, per depositor per insured bank. FDIC insurance is backed by the full faith and credit of the United States Government. For more information on FDIC Insurance go to www.FDIC.gov. Unlike ordinary CD’s, these do not pay current income and the investor has to hold the investment to maturity for the strategy to be successful. If the investor liquidates before the stated maturity they may receive back less than their original principal.

Most individual investment portfolios are limited to a combination of cash, bonds, equities, real estate and perhaps some managed futures. In today’s markets too many investors are reducing their equity exposure due to a fear of losing principal. Fear drives overweighed allocations to cash and bonds. While past performance is not indicative of future performance, it is a well known axiom that equities have outperformed cash and bonds in the past, especially over the last 60 years. In my opinion, most investors today, after a careful review of their portfolio and risk tolerance, need equity exposure to achieve their long-term investment goals. Market Linked CD’s offer conservative investors a new vehicle to participate in the markets while reducing principal risk.

In the past only institutions and very high net worth individuals have been able to access these complex, performance-linked investments in a variety of asset classes that offer in tandem 100% principal protection on the downside combined with the upside potential of the linked asset class. According to the trade group Structured Product Association new issuance of all structured products in the U.S. has risen from $28 billion in 2003 to $114 billion in 2007.

FDR proclaimed in his first fireside chat “Let us unite in banishing fear” March 12th, 1933. We are fortunate to have new financial tools to help accomplish financial security in today’s market environment.

It is important you talk to your financial advisor before you invest. Some topics to discuss are your tolerance for risk, time horizon, your market outlook, and interest in particular asset classes, expenses, taxes, computation variations and participation rate, maximum and minimum interest rates, prepayment penalties, current income requirements and secondary market activity if any.

Open architecture is also a concern. When an investor is only offered the in-house brand he or she may be at a disadvantage. It is generally better when banks compete. Typically, independent broker dealers can secure CD’s, bias free, from many different issuing banks.

This is not intended to be an offer or solicitation for the purchase or sale of any investment.

Robert Spicer is an Executive Vice President at First Financial Equity Corporation in Greenwood Village, CO. He can be reached at 303-643-5959 or rspicer@ffec.com. Member FINRA/SIPC

Open-Architecture in Slo-Mo: Investment News

Structured market leery of open systems
Yet brokerage firms' proprietary-only policy sparks risk concerns amid credit crisis

By Dan Jamieson June 2, 2008

Open architecture has been slow to come to the structured products market.

Structured products are unsecured debt obligations of the issuing brokerage firms, and despite growing concerns about Wall Street's financial strength, only one wirehouse sells outside products.

UBS Financial Services Inc. of New York has given its brokers a choice of issuers since 2006, said UBS spokeswoman Karina Byrne.

In addition to its own products, UBS offers products from Lehman Brothers Holdings Inc. of New York, Deutsche Bank AG of Frankfurt, Germany, HSBC Holdings PLC of London, and Barclays Capital, the New York-based investment-banking division of London-based Barclays Bank PLC.

Other than UBS, there's been no movement to open the doors.

Flows into structured products have almost doubled from $64 billion in 2006 to $114 billion in assets in 2007. Five years ago, in 2003, it was $28 billion.

The risk from a proprietary-only policy is that clients may not get the diversification they need, and they may pay too much when issuers don't have to compete.

Other than UBS, the only other traditional firms offering outside products are the private banking units at JPMorgan Chase & Co. of New York and Credit Suisse Group of Zurich, Switzerland, Mr. Styrcula said.

"If they did [use outside issuers], I would probably consider [structured products] a lot more seriously," said a Smith Barney rep who asked not to be identified.

For the full article, click here.

NASDAQ to Host SPA Press Event on June 11

On June 11, 2008, the NASDAQ and the Structured Products Association (SPA) will co-host a media briefing to discuss why "structured products" represent the fastest growing investment vehicle for American investors.

With nearly 7,000 structured products sold in the United States in the last year, this investment class has been resilient in turbulent markets and nimble in monetizing current market opportunities.

The Structured Product investment class outsold closed-end funds and convertible securities last year and was third behind hedge funds and exchange traded funds in new assets. Structured Products are rapidly becoming a mainstream investment instrument for millions of American investors, taking its place along side mutual funds, exchange traded funds, closed-end funds and stocks and bonds in well-diversified portfolios. This presentation is intended to provide the press with an overview of the structured products investment class and this rapidly developing industry.

WHO:
John Radtke, Executive Director, Incapital LLC
Karen Fang, Managing Director, Goldman Sachs
Matt Ginsburg, Executive Vice President, Wells Fargo
Nikki Tippins, Managing Director, J.P. Morgan
Philippe El-Asmar, Managing Director, Barclays Capital

IHT: U.S. to toughen regulation of commodities markets

by Diana B. Henriques
International Herald Tribune

Regulators of the nation's commodity markets will demand more information about investors to determine whether they are evading market limits on speculation and artificially driving up world food prices.

The regulatory agency, the Commodity Futures Trading Commission, also plans to initiate talks with bank regulators to ensure that adequate credit is available for the farm economy.

Finally, in an unusual departure from the secrecy that usually cloaks its enforcement actions, the commission will confirm that it is investigating the price spike that hit the cotton futures market in late February, a step demanded by cotton industry executives at a commission hearing on April 22.

The commodity futures markets play a key role in establishing worldwide prices for wheat, corn, soybeans and other foodstuffs, as well as energy products like crude oil and natural gas.

But in recent years, these markets have also become an attractive haven for investors seeking both profits from rising prices and protection against inflation and a withering dollar. As a result, billions of dollars have poured into the commodity futures market — from pension funds, endowments and a host of other institutional investors — through the new conduit of commodity index funds.

Billions more have come in from investment banks that are hedging the risk of complex bets, called swaps, that these same investors have made in the unregulated international swaps market, which dwarfs the regulated markets supervised by the CFTC

The commission has come under fire, most recently at a hearing on May 20 before the Senate Committee on Homeland Security and Governmental Affairs, for not doing enough to monitor the impact of these investors on markets that have such influence on family budgets nationwide.

Specifically, the commission will start requiring more information about index funds and, more significantly, about the clients on the other side of the unregulated swaps deals that are being hedged on the regulated futures exchanges.

The swaps market has traditionally be seen as off limits for U.S. commodity regulators, but the commission clearly is responding to congressional concern that investors may be using swaps dealers to evade rules that limit the size of their speculative role in regulated markets.

The commission is also putting the brakes on granting waivers that have exempted some commodity index funds from speculative limits, and is formally dropping proposed rule changes that would have extended a blanket exemption to all index funds.

In recent years, more than a dozen commodity index fund companies have been granted individual waivers, after successfully arguing that they were using the futures markets exclusively to hedge their obligations to the people who have invested in their index funds. But the commission now intends to "be cautious and guarded before granting additional exemptions in the area," according to the draft proposal.

The full article can be accessed by clicking here.

Structured Products All The Rage (Hartford Courant)

But Consider Cost, Liquidity, Complexity

It seems like the perfect pitch for retirees: a financial product that protects principal and offers some growth potential to help fight inflation.

Or, still a decade or so from retirement but needing to boost returns to hit your number? Another product won't protect your downside but promises twice the market's positive return.

These are just two examples of the booming structured-products industry, which last year saw new U.S. issuances jump 44 percent from 2006, to $114 billion, according to the Structured Products Association, a New York-based trade group.

Behind the appeal of enhanced returns or insuring investors' principal, however, are concerns about the products' cost, liquidity and complexity for retail investors.

Financial institutions sell the notes under a variety of names in increments as low as $1,000, offering returns linked to particular market results over a period of time, say, three to eight years. One type of note might offer twice the return of the Standard & Poor's 500 index if it goes up (subject to a cap), but would have full exposure to any decline.

Another type might cap positive returns at a slightly lower figure but offer some downside protection — say, covering the first 10 percentage points of loss.

In the case of principal-protected notes, the contracts might be a hybrid of an FDIC-insured certificate of deposit issued by a bank and an option on the S&P 500 index issued by a brokerage firm. The investor essentially would receive the return on whichever performed better.

Many mutual fund companies and brokerages offer structured products on their trading desks, though often it involves a phone call to a representative to get to a full menu of all the notes being provided. Big players include JPMorgan Chase, HSBC, Morgan Stanley and Merrill Lynch.

Fees typically are embedded into the products, so consumers may find it difficult to comprehend total costs. There are underwriting fees to the banking firm that creates the product and brokerage commissions that combined could exceed 3 percent of an initial investment. Tack on ongoing management fees and the implied costs of caps on earnings.Some buyers have taken to the secondary market — financial exchanges — to escape the issue costs, but the flip side is that sellers trying to unload the products before the term expires have at times been stung by that illiquidity.

One concern is issuer risk. Given the problems in mortgage-related and other derivatives, consumer advocates worry that retail investors could get swallowed up in a round of defaults.

The derivative products also don't pay dividends like you'd receive if you made a direct investment in a stock-index mutual fund.