Dec 7, 2010

What’s Behind the U.S. Structured Products Industry’s $50 Billion Record Year?

Written By Guest Blogger, Keith Styrcula--Chairman, Structured Products Association

By all measures, the structured products investment class is on track for a record year.  According to Arete Consulting, overall issuance of these unique instruments in 2010 is up 24% -- on track for a first-ever $50 billion year.

The volume has taken many market professionals by surprise.  Bloomberg BusinessWeek recently noted that the issuance of structured products has become a prominent source of activity for the major issuers; for the first time, the revenues of the structured products desks are surpassing those of the investment banking.

Market conditions continue to be a challenge.  According to Morningstar, assets in U.S. stocks decreased for the fifth straight month, with investors withdrawing $65.1 billion from domestic, long-only equity funds since April 2010.  Some pundits believe there is more “cash on the sidelines” than there is invested in all the stocks of the Wilshire 5000 index.

In such a challenging environment, what explains the ascendancy of structured products?

It may be instructional to refer back to the dot-com meltdown of March 2000.  When the reality of “cash-burn” caught up with the high-flying dot-com stocks, the ensuing market meltdown saw the major indexes lose 35 to 45% of market value.  Yields on risk-free money markets plunged to less than 1%.  The equities market went sideways for several years before recovery.

The pre-eminent private banks created highly productive investment opportunities that permitted clients to repair their portfolios more efficiently than other investors who relied on asset allocation.  In the early 2000s, structured products provided investors with opportunities to:

  • Upsize yields
  • Protect principal
  • Enhance returns on index-based investments
  • Provide exposure to alternative markets such as BRIC equities, MLPs and commodities

Flash-forward to 2010.  Structured investments continue to provide unique opportunities for investors to recover from the credit crisis, with new and improved strategies.  Indeed, no other investment class responds to rapidly shifting market conditions as effectively and efficiently as structured products.  In sum, the reason the market is booming for these instruments is simple: investors, by and large, are having highly positive experiences with this investment class, and they’re returning time after time. 

Unfortunately – and predictably -- much of the recent coverage of structured investments fails to convey these positive attributes about the investment class.  Instead, a conspicuously vocal group of critics have arisen to make a cottage industry out of exaggerating the risks of investing in structured products. 

Here are the top three pre-occupations of these critics:

Criticism #1: Structured products have significantly greater credit risk than other investment alternatives.  In the wake of the September 2008 default of Lehman Brothers, the financial press has put forth a case that structured investments are inherently “risky” because they have the credit risk of the issuer.  This simple contention fails to take into account that structured products have precisely the same credit risk as the issuer’s other securities -- equities, bonds, notes and convertible securities.  The same critics who claim structured products have enhanced credit risk neglect to warn potential investors against the credit risk inherent in owning stock outright.  For example, ask the holders of Lehman Brothers equity if they’re better off than the fraction of holders of Lehman Brothers’ structured notes.  The once-in-a-century default of a 157-year-old investment bank was an unpredictable event that impacted all investors, and structured products holders were a small percentage of those affected.

Criticism #2:  Structured products have embedded derivatives and retail investors are not astute enough to own such instruments.  Much has been written about the complexities of derivatives that provide the unique payoff profile of structured products.  Absolutely true.  Structured investments are not plain vanilla, index-based investments – they’re explicitly for investors who seek some form of principal protection, enhanced income, tax-efficient exposure, or leveraged indexing.  It’s also true that a particular investor need not be an expert in derivatives to invest in a structured note, as long as the investor is inclined to read the risk section of a prospectus, and familiarize himself with the scenario analysis in the prospectus.  Any investor who does not familiarize himself with the risks of investing in structured investments should not commit his risk capital.  At the same time, however, nor should such an individual invest in equities, bonds, mutual funds or convertible securities. 

Criticism #3: Structured products have many hidden fees which are impossible for retail investors to figure out.   This is perhaps the greatest myth that afflicts the reputation of structured products.  It is critical to understand that the fees affecting the investor return are fully and conspicuously disclosed in the prospectus.  More to the point, such prospectuses are, generally speaking, drafted by the most prominent law firms in the world, detailed with great care and precision.  The structured products industry is always surprised to read about the financial media’s pre-occupation with structured products fees when – according to Lipper -- mutual funds charge an average of 1.2% per year,  Closed-end funds can charge up to 4.75% as a front-end load.  Generally speaking, side-by-side comparison of longer-dated structured products and other investment classes would reveal that 80% of structured products charge less than other, comparable index-based investments. 

In the end, the myths that perpetuate about structured products are a distraction from the true utility of the investment class.  One of the top financial advisors in the country by AUM recently stated at a conference that he hopes most of his competitors don’t become conversant with structured products.  “It’s the secret weapon I use to outperform my competitors.  I hope they stick with asset allocation as their calling card.”

The investment professional who has the expertise and the aptitude to become familiar with this investment class has a new, significant edge over her peers.  Structured products allow the accomplished financial professional to dial-out the undesirable volatility in a client’s portfolio, while layering in the market exposure most optimal to the investment objectives.   

Agreed: structured products are not for every advisor.  But for many financial advisors, it’s the strategic edge that allows them to outperform.  The time has come to re-approach the investment class with an open mind.

Blog Post - Apr 13, 2010

LIBOR Market Models for Smile-Dependent Exotics

Need Assistance?

Want More From Numerix? Subscribe to our mailing list to stay current on what we're doing and thinking

Want More from Numerix?

Subscribe to our mailing list to stay current on what we're doing and thinking at Numerix

Subscribe Today!