Bucking the trend

Unlike most US distributors, Foldes Financial Management has serviced its high-net-worth clients by avoiding the main staples of reverse convertibles and principal-protected notes, with the aim of providing a low-risk and tax-efficient means of managing their wealth. Sophia Morrell reports

The US structured products market has long been dominated by reverse convertibles, which have been a perfect match for the typical investor's passion for equities. But Miami-based Foldes Financial Management (FFM) has avoided the products entirely. "We haven't done any reverse convertibles," says Tom Balcom, investment adviser at FFM. "We don't use them internally as a firm because they are more like a single stock. Granted, there are some nice yields there, but we are focusing more on the broad-based indexes," says Balcom.

The majority of the advisory firm's products - two of which are usually on offer each month - link to commodities or equities. One note launched last month offered exposure to three equity indexes: the S&P 500, the Russell 2000 and the MSCI Eafe. The two-year product offers 200% participation in an equally weighted basket of the three indexes, and features 10% downside protection.

Indeed, capital protection is another area where FFM has set itself apart from the crowd. The firm offers no capital-guaranteed products because they invoke the thorny 'phantom income' problem (where investors are taxed annually on non-realised gains as well as at maturity) which has so far hindered the development of the US market. "A 20% buffer would be the typical note for our firm," says Balcom. "We don't want our clients to be hit with phantom income, so we don't do any products that are 100% principal protected." This includes certificates of deposit (CDs), which have been popular with investors owing to the Federal Deposit Insurance Corp insurance that covers them. "We're still very well diversified," says Balcom. "We get the CD exposure through corporate and government bonds, so if a client needs exposure to CDs then that's what we use."

Nonetheless, the ability to offer protection on the downside has created a unique appeal for structured notes compared to rival financial products such as exchange-traded funds and mutual funds. "It's what is called a game-changer - some of these notes are game-changers because of the protection that they can offer," says Balcom. The firm started off its structured products business in 2007, investing a small amount personally before launching the fully fledged note offering.

Most of the firm's clients are conservative investors with little interest in speculative or aggressive styles of investment. The average client on FFM's books has between $1 million and $10 million to spend, and most are either on the cusp of retirement or are recent retirees. For the latter group, the firm uses capital gains from structured notes to supplement the fixed-income section of a portfolio. Capital gains are more tax-efficient than regular income, so this provides some relief. "For example, commodities have seen strong gains in the past couple of years, so we have used capital gains from them to generate income. It's a combination of income plus capital gains to provide retirees' cashflow needs," says Balcom.

Diversification is the cornerstone of FFM's approach to retirement investing, not just in asset classes but also issuers - its importance underscored by the collapse of Bear Stearns. "We use several providers because people are worried about credit risk. I would hate to be in a position now where we used just one issuer and it was Bear Stearns," he says.

Prudence over counterparty risk extends to individual portfolios, where a variety of notes will all use different issuers. Among the bank's that FFM works with are HSBC, Morgan Stanley, JP Morgan, Credit Suisse and Deutsche Bank, mostly on a reverse enquiry basis. Minimum trades can be as low as $1 million, which the firm once undertook for an S&P 500/MSCI Eafe buffered note.

Defensive strategies have paid off for FFM, especially in the area of commodities. "A few months ago we saw that commodities had experienced a huge run-up, so we wanted to be more defensive in that category, and we used some buffered notes there," says Balcom. The firm offered a three-year Morgan Stanley note linked to the S&P GSCI Excess Return, which offered uncapped 100% upside participation with 26% downside protection. If the index is less than or equal to its initial value at strike, down to 74% of this level, investors will receive back their principal. He explains that the firm is still bullish about the long-term prospects for commodities, but adopted a defensive stance in the short-term in case of falls, which is why it opted for over 20% protection - an outlook that proved astute given recent corrections. FFM plans to continue this strategy with future notes. "We look at the asset classes - for example if there was a huge increase in equities over the next three months we might need to reposition," he says. "It's a combination of art and science."