The sale of structured products has grown rapidly over the past few years, primarily among advisors who are affiliated with broker/dealers.
A structured product uses financial engineering to create an investment that might not otherwise be available – one designed to protect a portion of principal in down markets but also capture market growth. The intention is to participate in markets with less risk than is inherent in buying securities directly or through mutual funds.
The products are built to pay off as long as the underlying market they are linked to (i.e., the S&P 500 Index or the Russell 2000 Index) performs within a defined range over a set time period.
We don’t buy structured products for our client’s accounts for one big reason, and a variety of small ones.
The big reason is that our Errors and Omissions insurance carrier won’t allow us to invest in derivative-based products. The financial engineering involved with derivatives creates risks that may work out well in the right circumstances but go beyond standard risks presented by the market.
Be that as it may, the small reasons that we don’t invest in structured products for our clients might be just as important. Buying a structured product can add both risks and costs to an investors’ portfolio. Here are some of the risks:
- The investor acts as a creditor to the company offering the product (usually the brokerage arm of a large bank). If the company goes out of business, even the principal protection written into the product becomes worthless unless it is built as an FDIC-insured CD with protection up to $250,000.
- There is no daily value of the investment to track. It’s a bit of a black box methodology. Often, the broker/dealer that creates the structured product (usually a CD or note) does all the record-keeping and makes all of the calculations to judge performance. There is no independent third party reviewing these calculations.
- The distributor of the product is often the only secondary market available if you need to sell your structured product before it matures. This means that this party can pretty much give you any amount they want for this product as there is not an actively traded marketplace for it.
Figuring out the costs of actually owning a structured product is next to impossible. The broker/dealer builds these costs into the investment so there is no transparency. Thus, the broker dealer wins, while the investor may or may not. Here are some of the costs associated with structured products:
- The hedging activities to create this structured product will drive up the costs of this investment. Some hedges are relatively cheap to put in place. Others are much more expensive depending on the index or market that you are trying to hedge. Often the costs of these hedges are built into the performance of the index that is being tracked. This detracts from performance.
- The broker/dealer often makes a profit on all of the hedging services that it provides for clients who buy these structured products. There is never any requirement that they try to attain best execution for the hedging trades.
If your financial advisor wants to sell you a structured product, it might be just what you’re looking for. Just make sure you understand all of the risks and costs, so you can really judge whether it is right for your portfolio. Even if it is, you probably shouldn’t commit a significant percentage of your overall investment to the strategy.
~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA