Structured Products: a prudent investment or an imprudent bet?

I wanted to start discussing some alternative investment strategies that are often not discussed or a just dismissed outright as being too risky. Today, I’ll start with structured products. A structured product is a fancy name for an investment vehicle that combines a traditional investment, like a bond, with a derivative investment, like an option, that generates a different return profile than the underlying assets. The best way to illustrate this is with an example of a common structured product, an equity product tied to the S&P500. This investment combines a zero-coupon bond plus a call option on the S&P500 with a maturity of 3 years. See the figure below.

Lets say you invest $1,000 in this product. Most of that $1,000 goes into a zero-coupon bond that at maturity will return your initial $1,000 investment. The rest of your initial investment buys an at-the-money call option in the S&P500. In 3 years, at maturity, you get your $1,000 back plus whatever the call option is worth. If the S&P500 is at or below what it was 3 years ago, you get your $1,000 back. If the S&P500 is above the level of 3 years ago, your return is whatever the gain was for the S&P500 plus your $1,000. Get it? You get the upside of investing in stocks without the downside, you get 100% of your principal back at maturity! Sounds good right?

Note: this is a very basic example. I’ve left out a lot of details to introduce the concept. See the following for more details; http://www.investopedia.com/articles/optioninvestor/07/structured_products.asp

Well, if it sounds to good to be true it probably is. And like any investment the details matter a lot. As you can see in the example, the details of a structured product are highly dependent on the underlying costs of establishing it. For example, if interest rates are very low, like they are now, then the price of the zero coupon bond will be high, thus leaving very little to invest in the call option. Next, if option prices are very high then the returns of the product won’t be as attractive. But if the product can be structured with attractive return profiles, and many of them are, then it is potentially an attractive vehicle for a conservative investor with a few caveats;

1. The product has a maturity date. If you need your principal back before the maturity date then you will get less than your principal back and be subject to fees.
2. You are subject to the credit risk of the issuer. These products need to be purchased from the highest quality institutions.
3. Since an option is being used as the investment in the S&P500 you get none of the dividends of the index, only the price appreciation.
4. There are fees associated with putting these products together. The fees vary a lot and are often not clearly disclosed. They should be made very clear.

The biggest negative of all, to me, is that it is practically impossible for an individual to put together a vehicle like this so you need to go to an investment bank or broker to buy one. And because of their marketing techniques that’s where the chances of investors getting fleeced goes through the roof. I’ll give you some of what I call ‘the fear articles’ on some of what goes on with these things.

The fear articles:

http://online.wsj.com/article/SB122636312365215727.html

http://www.nytimes.com/2010/10/21/business/businessspecial3/21PRODUCT.html?src=busln

Now, that’s over, lets get to the nuts and bolts. Of course there are risks, and some shady peddlers of these products but I think these products can be used quite intelligently to protect wealth. These products originated in Europe, are used there and in Asia extensively, and are used by very wealthy individuals and private banks. In the US, we often get a lot of fear mongering, some rightly deserved, over complex investment products often to the detriment of the small investor (a soap box I’ll jump on another time). I prefer clearly understanding the risks, the opportunities, and making well informed investment decisions based on the data.

For me, the principal protection feature of these products is extremely attractive. As I’ve mentioned before, for retirees, avoiding large draw downs of principal is just about the most important investment goal. I address the 4 risks above as follows;

1. I never put money into a structured product that I may need before the maturity date
2. I only buy from the top institutions. They pretty much have a government back stop and the structured products can even be FDIC insured.
3. I never use equity structured products. The foregoing of dividends is too big a price to pay for me. Dividends are too great a return enhancer to give up. Thus, I only use these products in non-dividend paying investments.
4. I make sure the fees are clear and detailed separately from the investment and are reasonable. There is a lot of competition out there, it pays to shop around.

I currently have two structured product investments; one in the Rogers commodity index, and one in a basket of foreign currencies. I view them as basically hedges against inflation (even deflation), a large devaluation of the dollar, and a play on emerging market strength. And commodities and currency investments are both too volatile and offer no income streams thus making me averse to holding them in the traditional manner, through ETFs. Both investments are 100% principal protected and have maturities of 3.5 years. They have some additional features like minimum return guarantees, return accelerators (participation rates above 100%), upside caps, that are nice but the principal protection is the key one for me. The link below has some more detail on the Wells Fargo products. They call them market linked CDs.

Wells Fargo Market Linked CD information:

http://www.rsrcpa.com/asset/Market_Linked_CDs.pdf

In closing, I hope this post has at the minimum been educational and shown some of the potential of structured products. They can be great tools if used correctly. And like the linked articles make clear, they can lose you money if used incorrectly. But isn’t that the case with any investment?