Structured products' risks

May 25, 2008|By Janet Kidd Stewart | Janet Kidd Stewart,Tribune Media Services

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 - perhaps 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. Big players in the field include JPMorgan Chase, HSBC, Morgan Stanley and Merrill Lynch.

Fees typically are embedded in the products, so consumers might 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 continuing management fees and the implied costs of caps on earnings.

Some buyers have taken to the secondary market to escape the issue costs, but the flip side is that sellers trying to unload the products before their 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 the dividends that you'd receive if you made a direct investment in a stock index mutual fund.

Still, the products have grown so fast that state officials in Massachusetts launched an investigation last summer into sales practices and have since issued industry guidelines regarding the products. They also made administrative complaints against at least one firm, alleging that brokers made false and misleading statements in their sales pitches.

The products are private contracts backed by the issuing firm and typically are regulated by the Securities and Exchange Commission, so investors can ask for a prospectus as a starting point in checking them out.

"Some people view these products as the investing Holy Grail. They have appealing upside and a potential to not lose money," said Jonathan Guyton, an adviser in Edina, Minn. "They might have merit in the right situation, but don't buy any product without knowing specifically what you want it to do in your portfolio."

Some advisers said most structured products don't offer investors anything they couldn't do on their own through the use of options.

But they do offer a way to bet on a market direction without worrying about expiration dates on options contracts, for example, and they can diversify strategies in a portfolio, said Kevin Alger, global head of equity solutions for JPMorgan's private clients.

And depending on the specific product - some carry imputed interest that must be reported to the Internal Revenue Service as income in taxable accounts - it might make sense to hold them in individual retirement accounts, planners said.

The bottom line, Guyton said, is knowing exactly what the products are supposed to be doing for your overall portfolio and awareness that there may be cheaper alternatives to consider first.

yourmoney@tribune.com

Janet Kidd Stewart writes for Tribune Media Services.

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