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How Will Structured Products Evolve From Here?

by Eric

As recently as the Fall of 2008, structured products (SPs) appeared on track to be the new darling of the investment world. New products were popping up seemingly by the day, and sales had more than tripled from 2003 through 2008, to over $100 billion. Then came the credit crisis and subsequent massive aftershocks to the financial system. Which raises the question: how will structured products evolve from here?

"Structured products" refer to a wide array of packaged investments that generally link fixed income vehicles like notes or CDs to the performance of equity, commodity, currency, or other indices. The allure of SPs to investors is their flexibility to accommodate personalized risk/return profiles and to access strategies previously only available to bigger, more sophisticated investors. For advisors and asset management firms, SPs constitute a new, differentiated, and appealing revenue-generating product.

Now, in the wake of all the turmoil of the last six months, there are some clear factors that point to SPs becoming more prevalent and important in asset management going forward. Other factors indicate the opposite. These factors are summarized in the tables below.

The allure of making institutional investing techniques accessible more broadly and customizing risk/return profiles to suit investor taste is unlikely to diminish. Products like Principal Protected Notes, which allow upside participation in the stock market while retaining downside protection, are well-suited to serve the growing demographic group thinking about retirement income and risk reduction while needing to maintain an opportunity for portfolio growth.

However, the drawbacks that SPs face in the current environment are not trivial. Investor distrust of "the system" is at an all-time high. Any opacity or complexity in a product will be treated with skepticism. Product proliferation and the availability of nearly infinite varieties of SPs risk confusing the market. Low yields on fixed income products, combined with the volatility-driven high cost of options, make pricing SPs attractively a challenge. And, more government oversight, regulation, and added compliance costs are a virtual certainty in the future.

Balancing all the factors, we believe that SPs are here to stay. In the short term, the SP market will continue to grow, driven by demographics (demand) and what advisors think they can sell (supply). Ultimately, however, product proliferation will reverse, and new cash flow and existing assets will consolidate into a few widely available and easy to understand structures (for example, PPNs and leveraged index vehicles that magnify returns). The likelihood of increased regulation and oversight, as well as investor trepidation and distrust, will mandate that SPs evolve to be more transparent, low cost, and standardized.