Participants in the US structured investment space have faced persistent disadvantages since its inception. Domestic investors have traditionally had strong appetites for stocks and mutual funds, while the punitive tax treatment on principal-protected notes means they are effectively taxed twice. Now the reality of a major issuer default risks setting the industry back even further, but the flipside of this is the creation of ideal conditions for certificates of deposit (CDs), which fall under the $100,000 protection offered by the Federal Deposit Insurance Corp (FDIC).
"There is a flood of money going into FDIC-insured products," said Matt Ginsburg, head of the customised investment solutions group at Wells Fargo, in his presentation on market-linked CDs. Ginsburg highlighted that volatility has sparked a stampede to principal-protected products, with greater sophistication developing around guaranteed offerings all the time. "You can link CDs to anything - long/short strategies, for example - but you still never get near the riskier end of the spectrum," he said. This results in some limitations though, as what is on offer has less flexibility than a structure in which some principal can be put at risk. And the deluge of cash is not as simple as it sounds - Ginsburg emphasised that investors are uneasy about ratings following the damage done by collateralised debt obligations (CDOs). Wells Fargo boasts a triple-A rating, but investors are questioning exactly what that means, he said.
Selling principal-protected structures is proving to be a very effective means of offering investors exposure to new asset classes, such as emerging markets currencies and commodities, as well as keeping investors in the market during downturns. "Buy high, sell low - lots of people suffer from this panic. But with principal protection, you can tell them to hold on and that in 18 months the certificate will be redeemed at least at par," said Ginsburg. "They get irrational and can't see an end to the gloom. Now is the worst time to abandon the discipline, but it is happening in droves." A positive consequence of this for the structured products industry is the massive outflow from mutual funds, which have seen $47 billion leave their management in 2008 alone, according to figures from the Investment Company Institute.
One of the biggest barriers to the success of capital-guaranteed products has been their adverse tax treatment - the 'phantom income' problem which leads to investments being taxed throughout their life and again at maturity. Worse still, the taxation of the structured notes family is far from straightforward. Notes will fall into one of three categories, explained Shamir Merali, a partner in the tax department of New York law firm Morrison and Foerster, depending upon whether they are principal protected and if they pay income. "The technical rules get very complex very quickly," said Merali. Unsurprisingly, the industry has been far from happy with the tax conditions as they exist, which were caught up in the general imbroglio surrounding the debate over exchange-traded notes (ETNs). This resulted in a Ways and Means Committee hearing in the US House of Representatives in March. "The debate got ugly in the spring," said Thomas Humphreys, also a partner at the firm's tax department. "Right now, the debate is really in a state of suspension - it depends on who is president next year. There is some uncertainty, although not as much as a year ago."
It was ETNs that originally prompted the ire of the mutual fund industry. While investors in those funds must pay income, ETN holders do not - the notes being taxed as pre-paid forward contracts at time of sale. "For taxable investors, this makes it a very attractive instrument," said Humphreys. But recent market events are likely to have a serious impact on the debate as it stands. Lehman's collapse and the ambiguity surrounding the future of its Opta ETNs highlights the vulnerability of investors in notes, and more importantly leaves the warring industries with more pressing issues to consider.
"Worrying about the tax treatment on ETNs (and exchange-traded funds) is the last thing on some people's minds given that we are seeing the entire restructuring of the financial industry," said Humphreys. He predicted that nothing would be seen from the Internal Revenue Service this year on the topic. Previously, critics of the system highlighted that although ETNs are technically a 30-year instrument, no-one seriously believed that the issuer would default, so people should be taxed accordingly. "Now people who said that are glad they didn't say it too loudly," said Humphreys.
First to default
Issuer default, unsurprisingly, dominated the discourse, as participants debated the best means of winning back investor confidence in a market already suspicious of derivatives. "To avoid counterparty risk, the option and the bond need to be split between investment banks," said Nathanael Bienvenu, senior structurer at Societe Generale Corporate & Investment Banking, during a roundtable discussion on how to boost volumes in the US. "We did one trade on a structured product without any credit risk to SG, creating a separate company full of bonds, so the capital guarantee was not coming from SG," he said.
Other solutions to credit risk were also put on the table - one of those being funds. "A mutual fund or an ETF is collateralised by assets, not by someone's promise. Whatever the assets are worth, that is what it comes down to," said John O'Brien, faculty director of the master of financial engineering programme at UC Berkeley. O'Brien described a fund created in 1992 by LOR associates (of which he was a founder) which was one of the first ETFs. Originally designed as a hedge product for institutional investors, the Index SuperTrust fund used an underlying ETF and returns were indexed to the S&P 500.
"New structures need to be explored," added John Lecky, North American sales manager at Dow Jones Indexes. "Investor confidence has waned and investment in ETNs has slowed down considerably, which is a shame, but there is still viability in it," said Lecky. He predicted a return to 'back to basics' structures: index-based, transparent products associated with well-known brands. "There are opportunities for the right products," he said.
One potentially lucrative area is retirement investment. These savings can be placed in tax-sheltered qualified accounts, which make principal protection a viable option. Structured products compare favourably to some of the existing options available, as demonstrated O'Brien in his presentation. Glide-path life cycle funds were one of the default selections for US government pensions, and have mushroomed in volume, explained O'Brien. While these investments can protect both capital and returns, they are weighted on the early years of the product, which means that investors can miss out on late gains. Unlike most structured products, life cycle funds are subsequently path dependent, and the levels of fees can have a devastating impact on returns - swallowing up to a third of invested capital, said O'Brien. This represents a huge opportunity for structured products to capture market share as a preferable alternative - what investors like about life cycle funds, O'Brien said is the idea of protection and locking in gains. Both of these are natural territory for structured products.
The final outlook on the industry's future from the client-facing adviser segment of the business was encouragingly positive. "In these times, structured products have been fabulous," said Tom Scott, CEO and president of Scott Wealth Management Group, during the adviser roundtable. "They do well in conventional and unconventional times - they have been great for both alpha and protection," said Scott. Other members of the panel emphasised how tough it is to convince investors that structured products are a viable option. "We still get resistance from clients despite explaining the products," said Gregory Farrall, senior vice-president of Lakeside Wealth Management Group. "It's not an easy process," he said, but CDs have helped him open the door. The final panellist, Howard Dent, who is marketing director of affluent markets at CD behemoth Wells Fargo, was also feeling bullish about the future of certificates. "In times of stress, people are moving from what they don't know to what they do," he said. "And they know CDs."
The week on Risk.net, July 7-13, 2018Receive this by email