Global Structured Products: Midterm Report Card
Event on June 21, 2006
Notes by Margie Yuan and Eric Shahinian
Event sponsored by the Structured Products Association
What are Structured Products (SP)?
• A contract between investor and issuer, large investment banking firms
• A combination of financial instrument: 0% Coupon + Derivatives
• Minimum Investment of $1000
• Payout period ranges from 1-7 years
• Upfront fee (1-6%) or commission
• Advanced technologies have enabled Baby-Boomers to live longer and to take on riskier investments.
• Baby-Boomers and investors nearing retirement, who are looking for a steady income stream but with higher returns than traditional bonds.
• Principal-protected note (PPN)- Guarantees the return of the original investment at maturity plus a percentage of investment gain
• Return-enhanced note- No principal protection. Promised return 2X or 3X of index with a maximum cap
• Hidden Fees
• Inadequate fee disclosure
• No dividend payout from equity-linked products
• Difficult to sell before maturity date
• Inadequate legal platform to fully support the complexity of Structured Products.
Several lawyers I spoke with voiced their concerns for the current legal platform, which has not been updated since 1930s and does not acknowledge the different degrees of risk between Structured Products and Mutual Funds.
Traditional instruments are misleading. Many believe that structured products represent an industry that composes financial instruments that simply do not work, yet note the following. Options often defy logic, i.e. and put and a call option will both rise when the corresponding stock drops 20%. Warrants, as many of us know, often move in very odd patterns, often not determined by the underlying issue.
Short selling in recent years has become not only a major source of scrutiny in the financial market industry, but also a major source of influence in the marketplace. Many claim that short selling ‘stabilizes prices’ and allows them to reach equilibrium, making the market more efficient. However stock lending was only made possible last year by the SEC, and so this has been going on without concern for many years, unlawfully. Short selling is even occurring in the T-bond market, with people benefiting on the rate drops, although now it looks unlikely to occur.
The SEC is rightfully cautious of the repo mechanism in short selling, essentially the short squeeze. Thus the brokers on the street are doing their best to prevent short drawdown, as it prompts many shorts to cover the positions. The SEC law still needs to be refined in terms of the t-bond and index futures markets.
What I am trying to establish is that the financial markets with regard to traditional instruments are not that valid and secure that people should naturally rely upon them for asset allocation. The structured products space has a lot to offer.
The Canadian economy is another place to look at in discussion of Global Structured products. Canada has tremendous resources to do phenomenally, and their economy is developing quite substantially. What is the best thing about Canada is their income trusts. Now I am sure many people are saying that they know what an income trust is, but they are different in Canada. They are generally for 3, 4, or 5 years in duration, and are meant as an ideal taxing structure for mature companies. It allows the companies to pay all gross income without corporate tax. Therefore, in Canada no issue exists of double taxation, thus helping boost the economy. We will be able to find a lot of value in Canadian products.
50% of the equity IPOs in 2005 were in the retail structured products space. To be more exact, 19 out of the 40 top offerings.
Principal protected notes, a big part of the structured products industry, are becoming a bigger product, with yield by the main banks. They employ a CPPI structure, with 1:1 gearing, and up to 200% exposure to a commodity or pool of commodities. This is a desirable structure because we have to remain cognizant of the fact that in Canada only 50% of all capital gains is taxed, creating a very favorable environment. Equity forward overlays are also important to be reminded of in terms of products with yield, as the distribution is not taxed until the capital investment is recovered, then the excess return is taxed. Products can now have split share capability, where you either have 2:1 capital distribution, or 2:1 capital appreciation.
In Europe, there has been a rational shift to thematic, simple payoffs. There is a commodities focus, which has traditionally been simply overweight. Water companies are emerging as a means of investment, as they have yet to be seen as a true source of stable revenues and solid returns. Spain is known for simple payoff structures, with strike prices out of the money in many, or almost all of the products. They also have cheap options relative to their neighboring countries, and so the environment is conducive to structured product growth. Scandinavia has been, and continues to be a ‘vanilla’ country so I will not discuss it further.
Some products to note are the fund/ index linked hybrid structure. They are essentially a ten year rainbow, and convergence has been occurring in terms of derivative basis into asset management companies. Structured products in many ways have been compared to mutual funds, especially relative to the fee structure in terms of load and such.
On to questions, innovation in the industry will continue to occur, driven mainly by the exotic structures products becoming more prevalent, as they have traditionally been much less regulated than their brothers and sisters, they offer much value. In terms of accounting for the products, that is a dilemma. Decomposition is required.
The future seems to hold many things, but what is likely is that what will occur, in addition to the change in use of exotic products, more so the traditional products will be optimized and hopefully be used to a greater extent. A drawback to this is regulatory concerns. I am frightened by what India has and continues to do; requiring derivative holders to disclose their holdings. This is ok for mainstream equity issues, but the derivative industry is very sensitive for this information, and it would be detrimental to achieve substantial returns.
The Middle East has many hedge funds entering, especially multi-strategy and fund of funds. The local equity markets are rising to enormous highs, and continue to rise, and real estate is also faring well. Money was invested locally until recently, but foreign investment expansion will be the key to develop the market there. More shareholder friendly products could help, as derivative option products are not allowed, with typically option + zero coupon bond structure. However interesting to note is that products still exist in similar forms, allowing us to conclude that the products are simply restructured in a way as to facilitate the product being offered pursuant to regulations.
A product that should be looked upon further in the mandatory exchange bond in terms of its use and the Time Warner/ Icahn deal. The offshore entity to accomplish its goal of returns can find usefulness in the product.
In the general marketplace, the structured products world impacts very little. There are an estimated 200+ products, with $20 billion of purchasing power. This industry particularly impacts the emerging markets as a very viable means to gain access.
Exchange traded notes are essentially a complex bundle of exchange traded funds. In general, it would be safe to say that we can consider structured products bundled instruments, often of debt and equity notes. Fees are something that this industry, much like the mutual fund, and especially hedge fund industry, is being scrutinized. Fees will likely go down substantially in the future. Hedge funds do not invest in structured products; they may use them to gain access to niche markets that are not typically available to them. Often times, however, swaps can be simply used to lever the returns. What needs to be clarified is that correlation swaps are OTC derivatives, not at all structured products.