Saturday, July 21, 2007

Get Ready to Structure Your Portfolio

STRUCTURED PRODUCTS ARE THE FASTEST-GROWING investment class in the U.S., according to their aptly named advocacy and trade group, the Structured Products Association. Although they’re not available on-line as yet, they will be before too long, and investors should be aware of their role in a portfolio.

Common in Europe, these are synthetic investments that are usually offered in the form of a bond or note with some guarantee about principal protection. Their payouts, which are generally higher than standard fixed-income securities, are tied to the performance of assets like equities, commodities, and currencies or indexes linked to them. As a result, they carry more risk. Investors buy them to meet needs, like hedging stock or currency positions, that aren’t readily available in single financial instruments.

STRUCTURED PRODUCTS ARE to Europeans what mutual funds are to U.S. investors,” says Keith Styrcula, the founder and chairman of the SPA trade group (http://www.structuredproducts.org). His organization estimates that approximately $194 billion in structured products were held in retail-investment accounts in Europe in 2006, versus $64 billion in U.S. accounts.

Styrcula believes that U.S. sales could hit $100 billion in 2007. Granted, that’s not much compared to the $1 trillion mutual-fund market, but as he points out, the robust size of the funds’ market “didn’t happen all at once.”

Currently, structured products (SPs) are most likely to be found in the portfolios of wealthy investors who have set up separately managed accounts. They can be used as part of the asset-allocation process to diversify or limit risk exposure of a portfolio, or as an alternative to a direct investment, usually through the use of a derivative like an option or for added leverage. They carry names like equity growth-linked securities, equity basket-linked certificates of deposit or index-linked notes, depending on the issuer, most of whom are major investment banks such as Merrill Lynch.

Fidelity, Schwab, Northern Trust, Claymore, LPL and Nuveen all have set up new SP distribution divisions in the last 18 months to handle more of these instruments, says Styrcula.

The potential to have principal protected, or mostly protected, for long-lifecycle investments is a particular draw right now. “There’s a lot of room for SPs to take share away from the variable-annuity market,” says Styrcula, who claims they’re cheaper and more effective in meeting retirees’ needs. In his view, SPs “are like ETFs with passive payouts. It’s the next generation of [exchange-traded fund] investing.”

But you can’t just log into your online brokerage account and find these instruments—yet. There are some structured products built into a handful of mutual funds, however. For example, Fidelity Strategic Real Return Fund (ticker: FSRRX) has elements that could be considered “structured products,” since 25% of the fund is described as “commodity-linked notes and related investments—structured notes whose performance is tied to the returns of the Dow Jones AIG Commodities Index.”

One issue preventing more widespread adoption of SPs is their black-box pricing. It’s not always obvious what the components of a particular SP are and the pricing can be opaque because various securities’ prices are included. If derivatives are involved, the terms can be even more complex.

WE’RE SEEING SOFTWARE developers jump into the market, which should make pricing more transparent, possibly speeding their adoption. For instance, NumeriX (http://www.numerix.com), which publishes pricing and risk analytics for fixed income, credit, foreign exchange and equity, announced that Bloomberg has embedded NumeriX analytics within a select set of Bloomberg Professional service calculators that should make pricing more readily understandable.

Kevin Sanborn, NumeriX’s senior vice president for integration, says these tools provide technology that should makes the market more comprehensible to the masses. “This is a technology to make the structure of the products more exciting and more accessible,” he says.

NumeriX, which offers other pricing analytics too, is also discussing putting a version of its calculator on the SPA’s Website to provide real-time pricing of various structured instruments.

When will you see structured products featured on your online broker’s site? If Styrcula has his way, soon.

Published in Barron’s, July 16, 2007

Posted by twcarey on 07/21 at 01:55 PM
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