srpIPS Has Found the Good in Derivatives

By: Lori Pizzani

Structured Retail

The firm states that by using only exchange-traded products (ETPs), it is able to ensure the liquidity and flexibility of its structured notes: “A typical Wall Street structure has very rigid terms, long duration, and high fees with virtually no liquidity. By letting IPS build and manage your structure we can offer mark-to-market pricing, full transparency, and the liquidity of exchange-traded products at a fraction of the cost.”

Paoloni who is not only the company founder bit its chief investment officer says that he studied various investment products and utilized a bevy of academic financial modelling techniques, and that by 2000 he had started to embrace the use of ETFs which brought up questions about the firm’s operational models.

According to Paoloni, long-term modelling simply didn’t account for serious market events like the ones in 2000 and then again in 2008. “[We asked ourselves] should we change our models for risk?,” he says. “Diversification works when you don’t need it, and it doesn’t work when you do need it.”

Tactical thinking
Being more of a tactical adviser, he took classes at the Chicago Board Options Exchange (CBOE) to learn how to use derivatives and asked his team to find ways of using derivatives to manage risks. “It changed how I was working,” he says. “We asked ourselves why aren’t we building more products using derivatives, and why aren’t others doing the same?”

Today, says Paoloni, the firm structures 100% derivatives-based portfolios to both hedge risk and provide an upside opportunity for all of his high-net-worth, pensions and endowments, and family office clients. “The firm is agnostic to market direction,” he says.

“We are not experts in this business. We are always learning,” adds Paoloni. “Options are more complex than other investments but volatility and time add a fourth dimension to the equation. Other people just aren’t willing to put in the time to learn.” He candidly tells other RIAs that derivatives have changed his life. “If other RIAs are not using derivatives, I think they are out of business. But they need to understand the mathematics,” he cautions.

“If you understand options you can build risk models to what clients want,” says Paoloni.

In particular he favors exchange-traded options as well as baskets of investment grade corporate bonds that allow him to diversify and mitigate corporate default risk while achieving a 300 to 350 basis points discount. He also likes the suite of Guggenheim BulletShares ETFs which invest in investment grade and high yield corporate bonds, and have defined maturities with specific maturity dates such as yearly ending in 2016 through 2022. (According to Guggenheim, each defined maturity ETF tracks 30 to 300 corporate bonds.)

According to Paoloni, he can then match a specific Guggenheim ETF slated to mature in, say, 2016 with an exchange-traded equity-linked product maturing at around the same time and offer 100% upside participation.

Index annuities
According to Paoloni, in the late ‘90s, several insurance companies began offering “fantastic” index annuities that looked like variable annuities but were guaranteed and included no risk. He jumped on the bandwagon, and recommended many of these to clients, including one from Safeco which offered a 98% participation rate with no cap for life.

However, says Paoloni, some insurers found that they had improperly created these annuities to the benefit of investors but which were costing the insurance companies millions of dollars in losses. The insurers consequently sent letters to investors hoping to convince them to switch into other annuities but which offered less favorable terms. To those investors who still hold these original excellent annuities, he offers a single piece of advice, “Never sell these” he says.

But by the early 2000s, many of these index annuities were restructured and went from wow to utter garbage, adds Paoloni.

As for the new batch of so-called structured annuities that have burst onto the scene within the past few years and offer structured product-like features such as a choice of underlying indices, performance caps and buffers against potential first loss of principal, Paoloni is not at all a fan. “They are an abomination,” he says. “The devil’s in the detail.”

While the allure is that the investor has a choice as to the index, the term and the downside buffers, “they (the insurance companies) can change the spread, they can change the performance cap and they can change the participation rate after the first year,” concludes Paoloni. “It’s all smoke and mirrors. With a little knowledge an adviser can build a custom structure right inside a client’s account with a much better value proposition.”