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Are Structured Products Really For You?

Wealthy investors use alternatives to minimize risk

By Fred Yager
ConsumerAffairs.com

August 19, 2008
For several years now, financial services companies have been promoting an alternative to traditional investments of stocks and bonds -- something called "structured products." They're sold specifically to qualified or high net worth clients as a way to hedge against the volatile stock market and as a way to manage risk.

On their face, they sound like safe, sound investments. So why aren't they available to everyone? Why are they only being sold to wealthy investors?

The simple answer has to do with the golden mantra of Wall Street regulators that says "you shouldn't invest in securities you don't understand" and structured products are not that easy to understand.

Even Treasury Secretary Henry Paulson referred to them recently as "highly complex structured products which are difficult to understand." You have to figure if Henry Paulson, who used to work for Goldman Sachs, thinks structured products are complicated, they're complicated.

Paulson went on to put part of the blame of the credit crisis on Wall Street, where he said "there was too much leverage in the system and more leverage than was appropriate and more than people recognized, because the leverage came into the system in the form of highly complex, structured products. So there was excess leverage, excess complexity."

While the current credit crisis stems from several factors, many point to the complexity of structured derivative products as being a key contributor. What started out a simple mortgage backed products soon evolved into fancier instruments such as Collateralized Debt Obligations (CDOs) and Credit Default Swaps (CDS). These insanely complicated products are so dense only a few Wall Street rocket scientists know how they work.

Not only do they stymie individual investors, but credit rating agencies and some of the world's biggest banks and brokerages didn't understand their risks and subsequently had to write-down billions of dollars from their balance sheets when the market in these derivatives collapsed.

Despite all this, structured products are among the fastest growing investment vehicles being peddled today and they seem to be getting more popular each time a new variation is introduced to the market place. According to www.structuredretailproducts.com, since 1995, there have been over 600,000 individual structured product offerings from 1,200 companies that update the listings daily. These products represent nearly $2 trillion in sales.

Therefore, it's probably a good idea to at least know what they are, just in case someone tries to sell you one. So bear with me as I attempt to deconstruct structured products.

What are structured products?

Basically, structured products are investment vehicles designed to manage risk. They do it by using derivatives to provide investors with different exposures to a range of asset classes, such as stocks, bonds, commodities, and even hedge funds. Derivatives, in case you don't know what they are, include a group of hybrid investments that derive their value from the performance of an underlying security such as a stock, a bond, index or other asset classes.

These traditional and non-traditional investments are then structured or combined with derivatives such as options, futures contracts and swaps. Swaps are agreements between two parties to swap or exchange future cash flows according to a prearranged formula.

All of this is supposed to give you more flexibility and control while providing varying degrees of protection and enhanced potential returns. In fact, many of the most popular structured products are designed to protect either some or all of the principal investment. That means no matter how bad things get, you won't lose your entire investment.

Downsides of structured products

There a number of downsides to structured products from a lack of liquidity due to the thin secondary market to capped returns, meaning you sacrifice a higher return for downside protection. Also, underlying all structured products are investments that look and act very similar to the kind of investments linked to the credit crisis.

Investing in mere stocks and bonds is scary enough. It can get extremely dangerous with some of these so-called "Frankenstocks," which is why they're supposed to be marketed only to those investors wealthy enough to withstand the risk. These vehicles could have risks that aren't so apparent or easy to understand. As a result, it might be difficult to determine how the investment itself will generate revenue.

When you buy a mutual fund, you make money if the securities in that fund go up in value. But if you have a structured product like principal protected notes that include a combination of guarantees and options, you're not going to have a clue as to whether that vehicle is a good investment or if you're paying too much for all those guarantees. The rule of thumb is the more complex the product, the less obvious the risks.

Don't forget the fees

Firms selling structured products aren't doing this for their health. These babies pay off big time. And typically the fee is built into the structure of the product so you don't even see it. But you can be sure somewhere hidden in the spreads between underlying assets and fixed into derivatives is the fee for building and selling the product. It's usually factored into the formula that determines payment at maturity.

Still interested in structured products, or any investment for that matter? If so, here are some questions you should always ask before turning over your hard-earned money to a financial advisor:

• How is this money going to be invested?

• Do you understand how the product will generate returns?

• What would cause you to lose money?

• Can you get the same or better results from a less complicated product?

If the financial advisor can't answer these questions, chances are he or she doesn't know what he's doing, so find an advisor who does.

Be sure you fully understand what you are buying before getting into a structured product. If you do your research, read the fine print, and then deal with someone with expertise in this area, these could be good investments and a welcome addition to your portfolio.

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