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Wealth Management Ideas for Volatile Markets

By: Matthew T. Marcom

Randomly adding financial products to a portfolio is a surefire recipe for suboptimal results. Most experts agree that the most direct route to achieving financial objectives is through a wealth management approach – a style that takes into consideration a person’s risk tolerance, time horizon and the overall big picture for developing a long-term plan that leads to financial security.

If your clients are committed to a wealth management strategy as a means of achieving their long-term portfolio objectives, now might be a good time to urge them to take a closer look at structured products. Indeed, there are structured products to fit all investor risk profiles and diversification approaches. If your clients are in the majority who now have a reduced appetite for risk, yield-enhanced, higher-quality structured products may be suitable for keeping their portfolios on track.

What is a structured product?

Leave it to the financial engineers to create products that give retail investors access to some of the same strategies used by institutions and hedge funds to supercharge performance. In basic terms, structured products are securities whose value is a function of the value of an underlying stock, bond or other security. They have been embraced by individual investors in Europe and Asia. Now, U.S. issuers are seizing the opportunity to design structured products with a wide range of features and risk/return ratios, which has driven their explosive growth in the United States over the past few years.

With the help of a wealth manager versed in structured products, these can be used for a wide range of portfolio objectives:

Firms that sell structured products aim to differentiate themselves with a variety of products and labels. A survey of the market will reveal ones designed for protection, yield enhancement, optimization, performance and leverage, as well as those linked to indexes, interest rates, foreign exchange and commodities. The American Stock Exchange lists about 85 percent of the structured products that trade on exchanges.

To make it easier for investors to understand and compare different products, the Structured Products Association has pushed the adoption of industry-standard terms. This would eliminate any confusion caused by multiple names for the same product. Some major issuers have already adopted proposed name conventions.

The usual suspects

Things to bring to your clients’ attention when looking at structured products are the same as those that apply to all investment products. Medium- to high-net worth clients most likely meet the suitability test. Some products are highly complex, and there is no guarantee a broker will be able to find your client a buyer if he or she decides to sell before maturity. Fees have come to the fore as an issue with all types of investments, and fees for structured products can be particularly hard to understand. The complexity also has implications from a tax perspective.

An IPI innovation

To give our higher-net worth clients the opportunity to profit from structured products, Investment Professionals Inc. consulted with SB Value Partners LP, a money manager specializing in conservative value strategies that has posted impressive returns during the past seven years. The new IPI offering is a type of structured product designed to generate high current income: a higher-quality reverse convertible security based on underlying stocks recommended by IPI analysts.

The typical reverse convertible security is a high-yield instrument that also offers exposure to the equity market; participation in the appreciation of the underlying security is usually limited. In most cases, investors in reverse convertibles take the view that there will be little change in the price of the underlying stock in the near term. A reverse convertible pays fixed, regular interest and principal at maturity based on the price of the underlying stock. Maximizing income is the primary objective.

In exchange for the higher coupon, the investor assumes full downside risk on the underlying stock without the opportunity to participate in any capital appreciation. If the underlying stock trades below a pre-determined level at maturity, the conversion mechanism is triggered and the investor receives shares of the underlying stock in lieu of cash.

Until the partnership with SB Value Partners IPI was reluctant to jump on the structured products bandwagon because existing products did not meet our company’s quality standards. This arrangement, which allows IPI to structure a reverse convertible with IPI-recommended stocks and terms, has given us the ability to offer clients a popular product that meets our high standards.

Sample issue

To illustrate our reverse convertible, let’s look at our February issue. The issuer set the coupon, the term and the level of downside protection, known as the knock in.

Stock: Garmin (GRMN)
Coupon: 10%
Term: 1 year and 1 day
Downside Protection: 37%
Strike Price: $55.80

Here, an investor receives a 10 percent coupon and a return of principal in one year and one day so long as Garmin does not close below $35.15 during the term of the note (37 percent down from the strike). If Garmin dips below the knock-in level and does not recover to the strike price by the maturity date, the investor receives shares of GRMN in lieu of return of principal.

Clients who purchase this type of reverse convertible can expect one of two outcomes:

1. If the underlying security never trades below the knock-in level, the client is returned principal at maturity and has earned a highly competitive coupon.

2. If the underlying security goes below the knock-in level and does not recover to the strike price by maturity, the client takes an equity position in a high-quality company.

IPI recommends a laddered approach to investing in reverse convertibles – and one that allocates 10 percent of a portfolio to these securities 1/12th at a time. So a client with a $1.2 million investment portfolio would allocate $120,000 to reverse convertibles in $10,000 monthly increments.

This would produce a basket of 12 high-quality reverse convertibles, each with a maturity of one year and one day. After a year, the client should receive coupon payments every 30 days, with an above-average yield on this portion of the portfolio and some downside protection in markets that are likely to see continued volatility.

As always, nothing written in the article should be considered investment advice by the author, IPI or SB Value Partners L.P. Individual suitability should always be addressed. Securities offered through IPI are not FDIC insured, carry no bank guarantee and may lose value.

Performance to date

We’re pleased with the performance of the IPI reverse convertible portfolio thus far, which in large measure is due to the analysis and selection of the underlying companies by SB Value Partners. Clients who participated in all six issues currently earn an average yield of 9.49 percent with an average downside (knock-in price) of 29.5 percent. Following are the stats for our first six offerings:

ABN-AMRO Best Buy (BBY: $47.19 Current Price)
8.2% Coupon
30% Downside Protection
$48.65 Strike Price
$34.60 Equity Trigger

ABM-AMRO Labor Ready (LRW: $23.75 Current Price)
7.75% Coupon
30% Downside Protection
$19.25 Strike Price
$13.66 Equity Trigger

JPM Garmin (GRMN: $84.57 Current Price)
10% Coupon
37% Downside Protection
$55.80 Strike Price
$35.15 Equity Trigger

Lehman Bros. Portfolio Recovery Assoc. (PRAA: $64.51 Current Price)
9.5% Coupon
20% Downside Protection
$54.80 Strike Price
$43.64 Equity Trigger

Lehman Bros. Western Union (WU: $20.67 Current Price)
9% Coupon
20% Downside Protection
$21.59 Strike Price
$17.27 Equity Trigger

ABN-AMRO/JPM/Lehman Bros. Champion Enterprises (CHB: $9.75 Current Price)
12.5% Coupon
40% Downside Protection
$10.24 Strike Price
$6.14 Equity Trigger

Matthew T. Marcom is national sales manager at Investment Professionals Inc. Contact him at 210-308-8800.

Copyright © September 2007 BankNews Publications