Custom Structured Investments: How to Combat the Devil in the Details

By: Dominick Paoloni, CIMA®

 

The popularity of structured investing is slowly moving its way through the financial community mainstream. Structured investing is a sophisticated technique that allows investors to reduce or eliminate the downside market risk, or leverage the returns, of the underlying asset class. By blending structured investments into a portfolio mix that may include traditional ETFs, or mutual funds, advisors can provide a suitable risk versus reward profile for any risk tolerance that far outweighs a traditional investment portfolio of solely stocks and bonds.

Pensions and endowments are starting to embrace using index options to manage risk and reap the benefits of shaping the distribution curve; however, the use is still limited. This does not mean that structural investing is new. Insurance companies sell $8 billion in structured notes to investors every quarter, according to Equi-Facts under the name” index annuities”. Banks have packaged and sold structured investments for over a decade, however, they do not publish information on the amount of money going into these investments. If so much money is going into structured investments, why aren’t more pension and endowments embracing this seemingly better investment alternative?

Digging into the details of structured investments, the devil starts to appear. Structured investments come in all shapes and sizes, so for the purpose of simplification we will limit our definition of a structured investment in this discussion to a fixed income debt instrument with a defined yield to maturity combined with exchange-traded index options to create synthetic protected put positions on the S&P 500. There are two moving parts in this type of structured investment—the fixed income piece and the index option piece. The index options are the tools that shape the exposure to the underlying index, either reducing the loss exposure or increasing the index gains. The fixed income component provides the cash flow to fund the options purchase, and also ensure a set amount a maturity. Because the value at maturity is dependent on the debt instrument maturing at par, the risk of default could cause a total loss even though the systematic, or market, risk is controlled.

Banks and insurance companies that manufacture structured investments typically use their own debt instruments as the fixed income piece, effectively backing the investment with the full faith and obligation of that corporation. If the company should default, the whole structured investment would default, which is devil number 1.

The second devil is hidden within the options contracts. Bank and insurance companies use over-the-counter (OTC) options contracts, which are not regulated by a central clearing house. OTC option contracts are privately negotiated and traded directly between two parties, and are subject to counter-party risk since each party relies on the other to perform. An example of OTC options-gone-bad is when Lehman Brothers entered into OTC option contracts with AIG to protect their mortgage pool. When the mortgage investments failed, AIG could not provide the agreed-upon protection.

The third and fourth devils in the details pertain to the cost of the structured investment. Banks and insurance companies embed high fees into the structured investment to cover large overhead costs. That high cost, the third devil, drains the value from the investment and forces the banks and insurance companies to build long term structured investments in order to provide adequate value. Lack of liquidity is then the fourth devil, as insurance companies and banks charge high surrender charges to get out of structured investment prior to maturity.

With all of the pitfalls of structured investments, it’s easy to see why pensions, endowments, and individual investors have not embraced them. But are these negative issues inherent in structured investments, or is there a way to build a better mousetrap?

Investment Portfolio Solutions (IPS) builds custom structured investments that address and resolve the problems associated with structural investing. The most dangerous negative feature of structural investing is default risk. There are only two ways to eliminate default risk, by either backing all the structured investments with US Treasury instruments, or by diversifying away default risk. Investment Portfolio Solutions uses the diversification approach and backs structured investments with a basket of fixed income instruments from a multitude of issuers, so that the default of any one issuer will not devastate the investment.

IPS eliminates the second devil by using exchange-traded index options, regulated and guaranteed by a central clearing house to mitigate the counter-party risk inherent in OTC options. A central clearing house demands each and every country-party to put up cash to guarantee the transaction.

Investment Portfolio Solutions is able to eliminate the third and fourth devils by charging lower fees and passing the savings onto the investor, which provides a short-term solution with tremendous value. The structured investments are built directly in the client’s brokerage account, eliminating middle-man, underwriting, distribution, and filing costs. Finally, Investment Portfolio Solutions custom structured investments are market-to-market which means if a client need to get out of a structure before maturity the custom-built structure will be broken and deliver the true value at the time of surrender.

Structural management is not being embraced by individual investor at this time because of its complex nature; however, it is the responsibility of those of us well-versed in financial management to educate our pensions, endowment and financial advisors on why structural management is a better roadmap to a healthy and prosperous financial future.

This article is intended for educational and informative purposes, and is not intended to provide specific advice or investment recommendations. Please consult IPS or another financial advisor before making any changes.