West Coast Boutique Crafts Custom Structured Products

August 21, 2014
By: Yakob Peterseil, Structured Products Magazine

Like someone who believes that what he is saying should be plainly obvious to all, Dominick Paoloni rattles off the shortcomings he sees with the structured products sold by Wall Street. These firms charge excessive fees, he says, have long tenors and point-to-point payouts, and expose investors to unacceptable levels of counterparty risk. In fact, Paoloni dislikes these products so much that six years ago he learned all he could about derivatives and started creating his own, out of a small office in Denver, Colorado.

Since 2009, the firm Paoloni founded, IPS Strategic Capital, has been building and selling custom structured notes for family offices, high-net-worth individuals and financial advisers. Using exchange-traded options and baskets of corporate debt, IPS will build capital-protected and principal-at-risk notes on several popular underlyings for a flat fee of 1%. As the notes are built directly into clients’ accounts, notional amounts can be as low as $2,000.

Working with derivatives means Paoloni prefers to build structures on underlyings with deep, liquid options markets, and he is particularly fond of the S&P 500, because it has the most liquid in the world.

In May, IPS Strategic Capital put together a buffered note linked to the index that carried a two-and-a-half-year maturity and offered 153% of the upside of the index performance, with a downside buffer set at 18.4%. The capital-protected version offered 101.5% of the index’s upside. The firm has also built structures incorporating other underlyings to resemble diversified portfolios. “We’ll put, for example, 20-30% in the S&P 500, 20% in the FTSE 100 or another European market and 20% in emerging markets, etc,” says Paoloni.

IPS Strategic Capital has to source the bonds and derivatives it uses to build its custom notes. Paoloni looks exclusively at exchange-traded options for derivatives, saying the use of over-the-counter leaves clients with an unacceptable amount of counterparty risk. Any underlying asset that has a liquid exchange-listed options market is therefore fair game for his structuring team.

Purchasing bonds involves more creativity. When interest rates were higher, Paoloni used to buy US treasuries, which had a deep enough discount rate to build attractive structures. These days, with interest rates having tumbled, in order to create structures with a reasonably short duration, he looks principally at baskets of short-term, high-yield corporates. Building baskets of at least 100 individual bonds limits the amount of collateral damage any single default can do.

Paoloni has also used specialised exchange-traded funds (ETFs) listed on NYSE Arca to provide the fixed-income leg of his custom notes. Guggenheim’s Bulletshares ETFs track baskets of 50 or more investment-grade or high-yield corporate bonds that all mature in the same year. For example, the Guggenheim BulletShares 2020 High Yield Corporate Bond ETF (BSJK) tracks high-yield bonds that all mature in 2020. This makes these particular ETFs handy building blocks for structures with a fixed maturity.

Following stints on Wall Street and at his own brokerage firm in North Miami Beach, Florida, Paoloni returned to Colorado, where he had gained his undergraduate degree, to launch IPS Strategic Capital in 1993. It was not until 2008, however, that Paoloni says he “really became engrossed” in the world of derivatives. “I was looking for stability through volatile markets and the only thing that could give me this stability was derivatives,” he says. “If I’m invested in a long put and the market crashes, there’s no way that put is not going to increase in value. It’s a mathematical certainty.”

Today, Paoloni is an adjunct professor at the University of Denver, where he lectures on derivatives. It is difficult to overstate the importance he places on education, having frequently come up against investors’ ignorance of certain financial products. He relates the example of the time he pitched a structured note to a family office, which was more concerned about the message it would send to their active managers than the benefits for their portfolio. “They told me their active managers have too much ego,” he says. “They said ‘they want to pick stocks, not build a structure’.”

“I’m going to be frank: if you’re a professional money manager and you don’t know how to use derivatives in your portfolio, that’s malpractice,” he adds.

Paoloni uses options extensively, both in the custom notes he builds for clients and in his Absolute Return Strategy fund, which manages money for pensions, endowments and fund of funds. It trades puts and calls to take advantage of the difference between the implied volatility and realised volatility of options on major equity indexes. Building custom notes complements his money manager role.

“Structured notes on the street don’t have liquidity – they’re long-term and they’re point to point, so they’re not locking those returns in,” says Paoloni. “That’s why small houses like ours, who really understand how to build these, have so much more value.”