Structured Products for Individual Investors: Stay Away

Oct.22.10 | About: UBS Group (UBS)

In my earlier life on the institutional side of the financial world I specialized in marketing "structured products" to corporations and institutional investors. I can tell you that our department was extremely profitable because the complex structure of these instruments made it difficult for most of the buyers to figure out what the underlying components of the product were, hence the spread (markup) of the product were far larger than those of plain vanilla products.

In structured products, unlike those traded on exchanges, there is no transparency of pricing. Furthermore, it is near impossible to know the value of the structured product over the life of the instrument. There is also no liquidity in most cases as the investor cannot sell the option prior to expiration.

To give one example, a "structured product" which combined a floor on the loss on an investment but limited the upside potential was relatively easily constructed combining a put purchase and a sold call option.

In fact, the worst thing that could happen for our structured product group was when some of the structured products began to be traded on exchanges with transparency and liquidity for trading. Why? Because that meant the end of the massive profit opportunities. Of course, most of these new markets were accesible only to large institutional investors.

With many of the profit opportunities no longer available in the relatively simple structured products, financial institutions moved on to market them to individual investors who do not have access to these institutional markets. Furthermore these structured products, unlike products traded on an exchange, carry the credit risk of the issuer.

The NYT had an article by John F. Wasik on such structured products Wednesday, titled An Investment for the Experienced (emphasis mine; my comments in italics):

DEPENDING on whom you talk to, structured products are either clever ways of hedging specific portfolio risks or another demon from Wall Street.

As vehicles that use derivatives to protect or enhance an underlying stock, bond or index, structured products are sold by nearly every major bank and brokerage house — and more than $34 billion of them were sold in the United States in 2009.

Yet they are not for investors who don’t fully understand them, because they are riddled with complexity, are mostly opaque and have lost money for investors in the past.

“These are complicated investments, and people should know what they’re buying,” said Tom Balcom, a fee-only adviser with Ibis Wealth Management in Boca Raton, Fla. He said he had “yet to put more than 35 percent of a client’s portfolio in structured products,” adding, “If you don’t understand what these products are, stay away from them.”

Sean O’Toole, 43, who owns and operates an event-marketing agency in Fort Lauderdale, Fla., worked with Mr. Balcom to add structured products to his portfolio.

(It seems Mr. Balcom is ok with his clients buying structured products for less than 35% of their portfolios.)

“I’m not betting the farm,” Mr. O’Toole said. “I like diversification. I’d rather be over-conservative if we see another double dip.”

An ultracautious investor concerned about the prospect of another huge stock market decline, Mr. O’Toole has two-thirds of his portfolio in cash and one-third managed by Ibis in structured products like buffered return enhanced notes, which put a cap on the potential gain in return for protection against a market decline. He pays no commission for the vehicles and a 1 percent annual asset management fee to Mr. Balcom. (Of course the large markups on these products is not visible to the investor.)

Before Mr. O’Toole bought structured products, he had experience with options strategies, an essential prerequisite for anyone interested in structured products.

(He should have kept to those liquid transparent options imo.)

While structured products are not household names, they are hot sellers, and sales growth is estimated to be about 24 percent this year, according to structuredretailproducts.com, a service that monitors the industry.

Banks continue to market them aggressively as well. Structured note offerings are up 58 percent this year (through August), according to Bloomberg. The global market for these vehicles exceeds $1.6 trillion.

(Could that be because institutional investors burned in the past by these investments have been shying away? After all, it is much easier to sell a big structured note to an institutional investor (as in the good old days) then to sell large numbers of small ones to individuals.)

But the numerous disadvantages of structured products make them ill-suited for investors who want low-cost, government-guaranteed or liquid investments.

Once you invest your money, you are essentially locked in for the duration of the contract. Brokers may say they can buy them back, but often little or no secondary market exists for many of them. They may charge you another commission to do so and not guarantee the price you initially paid. Despite their many promises of principal or downside protection, investors can still lose money. Investors in principal-protected notes issued by Lehman Brothers (OTC:LEHMQ), which filed for the largest bankruptcy in history on September 2008, found out the hard way that they held unsecured Lehman debt. Their principal was not protected, and most lost all of their investment.

Structured products have been linked to an estimated $1 billion in investor losses in the Lehman notes alone. UBS (NYSE:UBS), the Swiss bank and brokerage firm, was one of the largest sellers of the notes and is being sued by investors and regulators in the United States and Britain...

Other structured investment vehicles like reverse convertibles and equity-linked notes are also the subjects of state investigations and investor lawsuits.

Don’t be cowed by the daunting calculus employed to hedge risk and produce returns. A competent adviser should be able to explain — and clearly illustrate — all risks (credit, market and liquidity), conflicts and expenses like commissions, underwriting fees, bid/ask spreads and embedded derivatives costs.....

If you don’t get a clear explanation or are uncomfortable tying up your assets in a virtually illiquid product, move on. These products don’t lend themselves to comparison and you can’t monitor them like you would a stock or mutual fund.

Most structured notes are “a hot mess,” said Janet Tavakoli, president of Tavakoli Structured Finance in Chicago and author of several books about them. “Most professionals can’t analyze them. When I have done it, I find these notes are loaded with hidden fees and hidden risks.”

Disclosure: No positions