Guaranteed to Protect and Serve Revision

March 31, 2010

Structured products prove a profitable investment for retail and high net worth investors, but for this to be a reality it is important to keep in my mind that it is imperative the client understand the nature of the funds as well as potential problems.

The purpose of capital-protected products is to give the investor real security by creating an environment, which benefits from rises in the market without risking the initial investment during downturns. The capital guarantee ensures that, at maturity, the investor receives all of or a substantial sum of the initial investment along with a return generally connected to an underlying investment.

People typically consider capital guaranteed options when the market is in a downward spiral. This is the wrong time to consider structured products. During periods of stagnation or decline, the cost of the guarantee of structured products tends to rise because of market risks and increased demand.

Capital guaranteed products have two parts: the ‘underlying,’ which is usually an index or basket of indices, and the ‘put’ option on the underlying. As market instability increases, so does the premium on the ‘put’ option. This is a result of increased costs of insurance. It is often more profitable to buy structured products when the economy is on the upswing because the cost of insuring the product is much lower.

New structured products have recently been developed, which further minimize exposure to market volatility. These new products reduce the risk by allowing portfolio managers to de-leverage index compositions on a daily basis. New formulas have also been created to undertake this process automatically reducing time lag.

Increasing the flexibility of the portfolio manager leads to increased profit possibilities by making it easier to avoid unnecessary risk. This process or tool is called a volatility adjusting mechanism. It applies to option based products (formula funds: a closed-ended fund with a payout based on a predetermined formula) and Constant Proportion Portfolio Insurance strategies (CPPI: trading decisions of portfolio managers cause the return).

The nature of structured products can lead to unfortunate after sale issues. During dramatic rises and falls of the market, the initial investment is subject to change as well. The structure of the note often permits the manager to minimize exposure to protect the capital during down periods, which may also minimize potential future profits. During upswings, the investor may receive a portion of the profits to pay for the insurance against market dips.

During the tech bubble and the recent economic crisis, many portfolio managers moved their investments into cash to protect the initial investments of their clients. Although this saved the initial investments from the financial storms, it also prevented these investments from taking part in the ensuing upswings.

Many investors are unaware that their investment may be removed from the market, but portfolio managers are devising new ways to protect capital to ensure that the investments weather storms but also enjoy the following good weather.

Capital protected funds are often more popular than structured notes with capital protection among high net worth investors. The elasticity and prompt market reaction of these products appeal to this demographic, but retail investors also tend to invest heavily in capital protected products. Retail investors enjoy the benefits diversification and opportunity for daily liquidity that these products offer.

Varying purposes define the use of principal protected products by retail and high net worth investors. Retail investors enjoy the diversity these products provide because they allow investment in volatile markets without exposing the client to as large of losses should projected gains not be met. High net worth investors can find comfort in structured products because they allow the investor to enter a murky market that promises big gains or losses with minimal exposure to drastic losses.

Raising capital for structured products has become increasingly difficult following the collapse of Lehman. Awareness of the necessity for understanding counterparty risk and the desire for clarity has tempered investors’ willingness to put their money behind capital guaranteed notes.

Formula based products assure investors because they remove human error during the investment period. The return is guaranteed at the initial investment. By making this initial guarantee, the investor also eliminates the right of good portfolio managers to navigate the market to maximize profits minimize losses also known as dynamic management.

Time Invariant Portfolio Protection (TIPP) is a new instrument that provides clients with protection along with the freedom of daily liquidity. Investment of this product follows the formula of CPPI or dynamic investment strategies, but the client forgoes a hit in protection costs and receives a smaller percentage of the initial capital investment in the event of a loss. The client sacrifices these insurance costs for the flexibility of daily liquidity. Investors who like to test the waters of the market before investment often respond well to this product and regularly exploit the protection of this product to gain a feel for new markets.

Products backed by capital protection or guarantees put responsibility on portfolio managers to explain the nature, positives and negatives of the product to clients. Ultimately, these variables are a composition a collection of complex financial concepts that most people do not understand. For that reason, it is necessary for portfolio managers to find effective explanation methods in terms the average person can understand.

As noted before, people often look to structured products during dips in the market. However, after a successful run in the market it is important to find ways to secure recent profits. This is when people should look into structured products to protect their gains while they wait for new opportunities.

Risk averse investors are apt to invest in structured products during down periods particularly but also during upswings and market moderation. An increase in demand for these products has caused an influx of new and effective ways to benefit investors while catering to their personality, likes and dislikes.

Investors regularly look towards equity indices for their underlings, but there are other options such as niche markets. These are more risky and thus raise insurance premiums. However, they can offer extremely lucrative returns.

Banks typically prefer structured products with capital protection to funds because they are usually more profitable, resulting in high competition between portfolio managers trying to sell capital protection funds. Competition piques in non-proprietary banking networks. Clients should be aware of this challenge, but capital protection funds also offer more counterparty security because the underlying is typically linked to several fixtures as opposed to one.