Playing Catch up

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Financial industry observers sometimes remark that the structured products business in the United States is analogous to the World Cup: the US lags behind the rest of the world in football, but when it catches up, it will do so in big way. And make no mistake, 2004 was the year that structured products went mainstream in America.

Sales of registered structured products in the US will finish the year above $12 billion notional, up more than 20% from 2003, when just under $10 billion was placed. For the first time, large retail institutions such as Raymond James, DB Alex. Brown, CSFB Private Client Services and Wells Fargo have hired structured products experts for their distribution channels to educate brokers about the risks and rewards of the asset class.

In addition, a November 3 article in the Wall Street Journal noted that exotic financial instruments are booming, with twice as many private investors holding return-enhancing derivatives in their portfolios than in 2000. Exotic investments are being promoted to the wealthiest clients as a way to boost returns, with as much as 5% of the portfolio to be invested in “options-like products”. Structured investment sales have spiked up at Citigroup’s Private Bank, JP Morgan, Merrill Lynch and Mellon Financial. At UBS, the Journal reported, demand for “options and other hybrid products for high-net-worth clients is running at a ‘record pace.’”

So why did all the planets line up for the structured products asset class this year?

The twin drivers are American investors’ continued aversion to risk and their search for respectable returns in tepid cash market conditions. With the equity market trending sideways and interest rates at historically low levels, 2004 saw a perfect confluence of events for structured products to become a more popular and robust slice of the asset allocation pie.

This was clearly the case with commodity and hedge fund-linked structured notes, as high-net-worth and institutional investors sought out absolute returns non-correlated to the returns of the equities and fixed-income markets. Oil, currency-linked and Asian equity basket securities were among the most notable exotic financial instruments launched since the beginning of the year.

Equity boom

As for the boom in equity and index-linked structured products, one member of the Structured Products Association put it this way: “The ‘Tech wreck’ reminded investors that risk is real, which makes them more willing to accept the trade-off offered by many structured investments – lower potential upside in exchange for less risk . . . or a greater chance of a good return, even if the market rises modestly, in exchange for a maximum potential gain for a small portion of the portfolio.”

Given current market conditions, market strategists and individual investors have downshifted their expectations away from perennial double-digit returns from large-cap equity portfolios, and have swallowed the bitter pill of more modest returns.

It is often said that one doesn’t get something for nothing with structured products. Investors have embraced this concept. They are willing to trade away a portion of the full upside of equity-linked products in return for capital protection, premium income from call overwriting or a capped two-times-upside product. If the structured investment offers a convenient, tax-efficient way to get an exotic exposure to the equities market at a reasonable cost, the US marketplace had become educated enough to create a significant demand for these products.

Innovation is the lifeblood of the structured products industry, and 2005 will bring even more exotic structured investment opportunities to American investors:

Interest rate plays providing embedded puts on treasurys and corporate bonds as well as interest-rate swaps will develop, as the Fed continues ratcheting up the prime rate.

Assuming an 8%–11% return in the post-election equities markets in 2005, look for more leveraged index-driven strategies (with a cap), index outperformance strategies, and volatility arbitrage plays to emerge.

Demand for so-called “alpha transport” structured investments will grow among pension plans, family office and institutional investors.

Hedge fund structured products will see exponential growth as US dealers learn from their European competitors how to model the risk of the products, and educate their best clients on the risks and rewards of a derivative exposure to alternative assets.

The Structured Products Association continues to experience growth in membership in lockstep with the candlestick chart of the business itself. The SPA is rapidly approaching 1,000 members, up from 300 at the beginning of 2004.

Wish list

As we compile a wish list for the coming year, we’d like to see:

Congress and the IRS revisiting the burdensome contingent debt rules that put US investors at a significant disadvantage versus investors from Europe, Asia and Latin America.

The mainstream financial media continue to publish more balanced and well-informed articles (such as the above-referenced Wall Street Journal piece).

The industry redouble its already significant efforts to educate the investing public and provide clear, balanced risk disclosure information on the products.

As for developing best practices for the growing structured products industry . . . that’s a new year’s resolution for all of us. After all, when you play in the World Cup, you’ve got to be at the top of your game.

Keith Styrcula is a JP Morgan Chase vice-president and senior marketer of equity structured products in New York. He is also the founder and chairman of the Structured Products Association and be contacted by email on [email protected]

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