By Eleanor Laise,
(c) 2005Dow Jones & Company, Inc.
WALL STREET firms are turning to retirement-conscious individuals as a growth market for arcane investments called structured products -- a trend that many financial advisers say puts investors at risk of buying something that doesn't suit them.
A structured product combines financial instruments, typically bonds and derivatives, into a single package that allows investors to make bets on the direction of stocks, commodities or other investments. Wall Street firms say many structured products are reliable investments in times of market uncertainty because they can protect the investor's principal, plus offer gains based on the market's movements. The products have long been sold to professional investors and the wealthy clients of private banks. Now, the firms that issue structured products are increasingly targeting smaller investors.
Interest in the products has boomed. The Structured Products Association, an industry group, estimates that nearly $49 billion of structured products were issued in the U.S. in 2005, up 57% from a year earlier. Although that figure includes institutional purchases, Arete Consulting, an international research firm, says it currently tracks more than 1,400 structured products for U.S. individual investors, nearly 650 of which have been launched this year.
But a number of financial experts say structured products are inappropriate for most individual investors. Besides high fees, the products can contain additional hidden costs, some experts say. They also can be difficult for investors to sell before the products mature. Regulators, meanwhile, have raised red flags that some brokers are selling structured products without adequately disclosing potential problems. "You just wonder how [individual investors] will ever understand this and why will they need all this?" says Phelim Boyle, a finance professor at the University of Waterloo in Ontario, Canada.
Financial advisers say investors can generally achieve stable investment returns through such traditional methods as maintaining a well-diversified portfolio of stocks and bonds, and adopting a strategy of dollar-cost averaging, which evens out purchase prices over time.
Still, Wall Street firms selling structured products say these can be a prudent investment for individuals, and the firms are expanding their offerings. J.P. Morgan Chase & Co. currently distributes its structured products through more than 80 brokerages that serve individual investors, up from 30 at the beginning of the year. Fidelity Investments recently started offering the products to its clients through the company's retail brokerage. And Incapital LLC, a distributor of third-party structured products, says its retail- brokerage customers have about tripled to more than 120 in the past year.
Though structured-product fees can be less transparent, they often aren't any higher than mutual-fund expenses, says Philippe El-Asmar, head of investor solutions, Americas, at Barclays Capital, a unit of Barclays PLC. Investors generally "are getting a good reward for the risks they are taking with structured products," he says.
A structured product is essentially a contract between the investor and the issuer, usually a major Wall Street investment bank. The issuer takes the investor's money -- $1,000 is a typical minimum investment -- and promises to make a payout based on a formula explained in the prospectus. The payout comes at the end of a fixed term, which often ranges from one to seven years. Investors don't know exactly what's being done with their money, just that the issuer has promised to make a certain payout at a certain time. Fees are generally taken upfront and can range from less than 1% to 6% or more, with more exotic products carrying higher fees.
A wide variety of structured products are being marketed. One popular type is the principal-protected note, which often guarantees the return of the original investment at maturity, along with a portion of an investment's gain, say 80% of the increase in the Standard & Poor's 500-stock index. More-complex products can be tied to movements in commodity prices or foreign currencies. Another structured product, sometimes called a return-enhanced note, might offer no principal protection, but could promise to return double or triple the performance of a market index up to a certain cap. Some structured products are designed to generate regular income. An inflation-linked note, for example, might offer monthly payouts linked to the consumer-price index.
Among recent offerings: J.P. Morgan sold five-year principal- protected notes that were linked to a basket of U.S., Japanese and European stocks. The notes sold in units of $1,000, which included $59.39, or nearly 6%, in fees. A Wachovia Corp. offering, which is designed for investors who want to bet that the housing market will continue to cool, is linked to a basket of housing-related stocks. If the value of the basket has declined at maturity in 2008, investors receive their principal plus a payout equal to 1.28 times the decrease in the value of the basket. If the basket's value is higher at maturity, investors receive their principal minus the full increase in the value of the basket, with a minimum payment of 90% of principal. The product carries an upfront commission of 2.25%.
Investors nearing retirement are a big market for the products, issuers say. Since baby boomers are living longer, they need to hold more stocks and fewer bonds in their portfolios to make their savings last through retirement, says Rick Silva, co-head of equity structured products at Wachovia. "The question becomes, 'How should you own the equities if you're going to own more of them?' " Mr. Silva says. "Shouldn't you have some principal protection?"
But regulators say some brokers have sold structured products without adequately disclosing the risks involved. The National Association of Securities Dealers, the brokerage industry's self- regulatory organization, suggested in a September notice that member firms might want to limit sales of the products to more sophisticated investors.
What are the risks? Investors in structured products that are linked to stocks typically don't get any of the dividends that they would have received if they had purchased the stocks directly or invested in a mutual fund. That's a major disadvantage, because dividends can account for a substantial portion of the stock market's total return over time. Another potential problem: The payout to investors is often tied to the value of the investment on a specific date. A temporary decline in value just before this date could cut into the investor's return.
Structured products also can be difficult to resell before maturity without taking a loss. While some issuers say they will buy products back from investors, there's no guarantee or requirement that they do so. A recent structured-product prospectus from Wachovia warns that "we expect that transaction costs in any secondary market would be high."
And the fee listed in the prospectus may not show the total cost of the product. Industry experts say it's all but impossible for individual investors to assess all the fees involved in a structured product and determine if they're overpaying because derivative pricing is complex and issuers can cap investors' returns in many different ways. Investors would have to "dissect the note and put it all back together to figure out how much the investment bank is taking out in fees. It's very difficult to do," says Janet Tavakoli, who sold structured products at major financial institutions before starting an independent structured-finance consulting firm. "When I was on the sell side I loved these products because of the fees I could stuff in" them.
Structured products come with some attractive guarantees as well as potential pitfalls.