Last year structured products sales in the U.S. increased to $117 Billion. And while most sales of structured products have occurred in the institutional and high-net-worth markets, the movement of structured products into the retail marketplace is clearly underway. What are the implications for competing products? According to Boston University Professor, Zvi Bodie, “The total amount of wealth that will be converted to structured products is in the trillions of dollars.”
The potential impact on other industries from the rise of structured products is one issue that Keith Styrcula, Chairman of the non-profit Structured Products Association, tackles in this interview. It’s not hard to imagine that the impact of structured products could be significant given the potent appeal of principal protection combined with investment growth potential.
David Macchia: Well, Keith, again, I’m very, very appreciative of your time. And I most interested in exploring the whole issue of structured products, the industry and your role in it. And I’d like to start with sort of a foundational question, if I could. Which is, given the fact that in the financial services world, apart from the sector that deals with structured products regularly, I think there’s a lot of wonder and mystery about what structured products really are? Could you start at the beginning and define what structured products are?Keith Styrcula: David, it’s a privilege to be speaking with you today. Structured products are fundamentally a variation on a direct investment in a particular asset class. Equities, fixed income, commodities — any type of traditional asset class can be the basis of a structured product. For example, a structured note linked to the S&P 500 might provide two times the upside up to a cap, or protection of your principal 100%, or the first 15% of the downside risk in the investment. Structured products may be described as enhanced ETFs – similar index exposure, but with a desirable benefit to the payoff profile that the investor values enough to pay for.
The notion of delivering equity-linked returns combined with a principal protection is a concept that’s I’ve written about a lot. Among others the Retirement Income Industry Association has certainly identified what we refer to as the transition management phase. Let’s describe that as the period beginning roughly 10 years before retirement and continuing until 10 years after retirement. It’s becoming well understood that investment losses during this period will, at the very least, diminish for life the amount of retirement income that can be generated. Or, depending on when the investment loss occurs, potentially lead to portfolio ruin. So when I think about the benefits that structured products can provide, I become pretty excited because you can see a role for them in the lives of potentially millions of boomer clients. So what I’m describing here is the context for the migration of structured products to the retail market. Is this something that the industry is focused on? Is it a high priority? How would you describe the urgency, if there is one, to enter that marketplace?My belief is that we’re at the ascendancy of structured products as the pre-eminent vehicle for the massive pool of boomer retirement wealth. Interestingly enough, the U.S. lags behind the rest of the world – Europe, Asia, Australia, South America and the rest of North America for that matter — is far behind the rest of the world in terms of principal protected exposure with guaranteed income. For Europeans, principal protected structured products are the equivalent of mutual funds to American investors. Europeans, by and large, value capital preservation over picking stocks and going for outsized returns. Americans have a different investment mentality. We believe that you can “asset allocate” risk out of your portfolio through diversification. Unfortunately, we have found that the fixed income and equities markets have a tendency to move in lockstep. The dot-com market break in 2000 proved how fallible that theory could be.
When indexes take 30, 40 and 50% hits and interest rates are so low that you get only 1 or 2% of return on your investment for a year without taking exceptional credit risk, structured products are simply the superior investment vehicle. You can repair your portfolio by selling call options in an automated structure, by purchasing high-yielding reverse convertibles.
The top 5 or 10 percent of cutting-edge investment advisors have embraced the structured products investment class and consider it to be the secret weapon that sets them apart from their competitors.
On the subject of principal protected notes, they would be a core holding in investor portfolios. But in the U.S., there’s something of a tax disadvantage if they are held outside of retirement accounts. The Structured Products Association has engaged Congress and the Treasury on revisiting this adverse tax treatment, but in the meantime, they are optimal investments for tax-free retirement accounts.
Certain structured products that with a ten year horizon, if managed the right way, can give you more than 100% exposure to the S&P 500. It can give you more than 100% principal protection. In fact, it’ll pay you a coupon of up to 1 or 2% per year at a minimum and give you full leveraged exposure to the S&P 500. As a core holding in your retirement account, it’s a very powerful value proposition for those who have that time horizon in their retirement accounts.
What you’re describing in terms of economic benefit seems obvious and important. And of course, John Bogle would think that investing in the S&P 500 is exciting. But what occurs to me is that because, for instance, you may think in terms of a ten-year timeframe for these products, with limited liquidity– I’d like to come back to the liquidity issue later– then having them in a strategic asset allocation within a retirement account framework seems to make a lot of sense. Do you agree?David, that’s absolutely right. Advisors who haven’t made the effort to understand the new technology have inaccurately stated that structured products are “gimmicks” with “high fees.” Such thinking is a disservice to their clients and their fiduciary responsibilities to provide the client with the best possible investment allocation. To disregard structured products is potentially a disservice to the client. To be clear, not all portfolios call for structured investments, but the advisor should arrive at that decision only after a careful assessment of her client’s needs.
If you accept the notion that accumulation planning is inherently different than income- generation planning, then you have to say that the majority of financial advisors in the U.S. remain in the accumulation mode mindset.That’s right, David. You could say that Modern Portfolio Theory is no longer so modern, and that structured products represent the next wave of MPT.
This implies, to me at least, that maybe the largest challenge the structured products industry faces is a communications challenge, in terms of recasting people’s thinking about these products. Educating advisors and investors about their use in proper income distribution planning, and getting people to focus on critical benefits that they currently they don’t see. Do you agree that communications is a huge issue for the structured products industry?It’s our number one priority as an industry. And I think you touched upon a very important point – it’s not simply education of the brokers and advisors on the utility of structured investments, it’s more about winning over hearts and minds. I’m going to be a bit controversial here: a good number of brokers and advisors have been intellectually lazy about learning about the investment class and have resorted to denigrating the investment class to the clients by saying, “Oh, it’s too high fee, too high risk, too complicated for you. So I’m going to do you a favor and steer you away from that.” Some advisors sell their own portfolio management skills by selling against structured investments. As an industry, we have our work cut out for us. And I spend a lot of time with the chief investment officers of the major wealth management firms advocating for this investment class, telling CIOs they should have structured products available to their top producers. So it’s a top-to-bottom/bottom-to-top education challenge before us.
And compliance has a role to play here. As advisors begin to recognize the importance of the benefits structure products provide, good compliance should ensure that these are properly conveyed.I emphatically agree, David.
Let me ask you about what you would certainly define as the “bad rap” that’s hung on structured products in terms of their being thought of as high fee products. How did that reputation emerge, and how accurate is it?In the early 1990s, when some firms began to offer structured products, fees were higher than they are today. Structured products were not alone -mutual funds were embedded with higher fees than we now have. The world has changed dramatically, and in 2008, there are as many as 60 issuers of structured products in the U.S. With such competition, fee compression is inevitable. That’s a very positive development encouraging the mainstream growth of these investments. UBS is the first wirehouse to open its distribution channels to multiple providers, and our surveys at SPA have demonstrated a significant fee compression over the last five years, with a remarkable acceleration over the last 18 months.
Let me ask you about the idea of the same entity playing the dual roles of manufacturer and distributor. Is that viable, given today’s compliance realities?The legacy of a financial services firm offering only its own structured products will inevitably give way to the European model, where they believe fiduciary responsibilities call for multiple providers. In fact, in the current credit crisis, with Bear Stearns as an institution disappearing over the course of a single weekend, it’s no longer intellectually justifiable to offer your clients your own credit exclusively. Look, best practices and fiduciary responsibilities call for a range of choices. Open architecture is inevitable.
Given the way you described the fee structures in structured products having been wrung out significantly since their debut some years ago, I think one can see an interesting contrast to another industry with another type of product that offers a similar combination of principal protection combined with upside growth potential. I’m referring to equity-indexed annuities, essentially structured products offered to the retail market by insurance companies since 1995.
Here we saw the odd example of fees that increased dramatically over time. Indexed annuities became more opaque, more confusing to people. And as a result, their inherent value proposition, as compelling as it is, became compromised, and a majority of advisors shunned the product.
When I think about this, Keith, I think that the insurance industry, generally, absent some radical changes in the way some of its products are distributed and communicated, may miss hit on what you would argue should rightfully be their opportunity to play the leading role in boomer retirement security. I suspect that this thought has dawned on structured products providers. Do these companies they look at indexed annuities? Are they aware of what’s happened in that marketplace, and how it radiates to other segments of the annuity industry? And do they see an expanding opportunity to take market share away from insurers?The variable annuities industry had first mover advantage for years, the big megaphone in boomer retirement. Tax-advantaged, guaranteed income – great value proposition. But the good will was squandered by embedding too many fees and adding complexity unnecessarily to the strategy. Now it appears that the industry is forced to reinvent itself by avoiding the word “annuity” and focusing on “guaranteed income.” And I see that as a cautionary tale for those of us in the structured products business.
That said, I think two pools of wealth that will embrace structured investments are – of course — the retirement world, but also the college education, the tuition money in the 529 plans. The 529 plans are exceptionally well suited to structured product technology and principal protection. The challenge is that the mutual fund industry has a stranglehold on that market.
Let me ask you about distribution for structured products in the retail marketplace. What does it look like now, and what might it look like in three or five years? The manufacturing capacity of structured products has grown at a much more rapid rate than the distribution channels’ ability to absorb them. Seven of the top ten issuers of structured products are those that have a proprietary distribution channel that’s closed to outside manufacturers. And that means that the rest of the 30 issuers are fighting over a 35% slice of the pie. The 25% slice is expanding very quickly, but not quickly enough to absorb of the 7,000-plus structured products issued each year.
Do you think that one of the keys to growth of structured products sales might be found in placing less focus on the product, and greater focus on the context? In other words, placing the focus on how structured products can play a vital role in a larger framework to create retirement income?Well put. The industry has something of a challenge simply with the name “structured products.” Why? Well, because “product” sounds like something being pushed. “Structured” sounds like it’s something with complexity. As a result, we need to simply our nomenclature, we need to articulate the value proposition, not the details of how we achieve it. When you buy a clock, you care only that it performs the function of telling time accurately. You don’t need to take the back off the clock and learn how the gears and flywheel works.
It’s also critical that the registered investment advisory channel becomes more engaged. RIAs are agnostic from a commission perspective. That’s why Barclays iPaths ETNs (“exchange-traded notes”) amassed $3 billion in less than a year. The advisory channel, is having a very positive experience with structured investments, and could be the future of our industry.
Let me take our conversation back into the insurance world and just remind our readers that the total accumulated values in all in force variable annuities and fixed annuities combined is about $2.5 trillion. When you consider that number and then compare it against the much larger amount of boomer assets that will be looking to be longevitized in the future, it makes one think that the balance sheet of insurance companies won’t be able to accept the full amount of assets that are available to be invested. This causes me to me think about the potential for strategic alliances, innovative business partnerships between the providers of structured products and insurers, where each are contributing their own inherent competencies in an alliance. I’m wondering if you’ve thought about this, if you see this as a viable potential for the future.Insurance companies with investment banks are oil and water. There’s a belief that they’re competing for the same dollars, but this is misguided. If the two industries combine forces, it is an undeniably powerful synergy. But from my experience in approaching insurance companies or 1940 Act mutual fund companies, there’s been a distrust, a rebuffing of strategic joint ventures or partnerships.
On the other hand, in the last two or three years, many 1940 Act companies are setting up their own structured products arms. And the insurance companies such as Hartford Life, are now actively into structured products. Imagine the power of taking principal protection or tax-advantaged leverage into closed-end funds or insurance wrappers. Combine these vehicles with structured products technology — it’s an incredibly powerful value proposition. But institutionally, you’re going to see some artificial impediments until all parties realize the value of combining forces for this massive market. There’s an enormous opportunity, and the synergy makes tremendous sense.
What you say resonates with me, but I clearly do see the synergy and business opportunity. And I think there are forward-thinking insurance companies. Currently, they may be in the minority, but I think that there are more than a few that will be amenable to interesting strategic alliances that are designed to make a large impact on the retirement income marketplace. I’ve got to believe that this is inevitable.I couldn’t agree more with you, but as with all major paradigm shifts, it will take time. You need a first mover, such as DWS Scudder to shake things up, combining structured products and mutual funds. Unfortunately, the mutual fund industry is aggressively lobbying against tax efficiency of some structured products. That’s short-sighted and anti-competitive – creating an adversarial relationship between the mutual fund and structured products industries. Not only is it bad for investors, but it’s a missed opportunity for the mutual fund industry, which would benefit from combining forces to provide tax-efficient strategies to American investors rather than seeking a political killshot to the structured products industry.
The tendency is always to hunker down and defend one’s religion, if you will. We see this in the advisory world, we see this among institutions. But the magnitude of this opportunity around boomer retirement security is so wide in scope that I think it calls for a more enlightened view among the leaders of these companies. And alliances where individual institutions are contributing their core competencies, I think results in synergy that benefits all institutions and certainly the consumer.In Europe and Asia, the top business schools issue numerous white papers on that topic. We need more of that in the U.S., some academic or commercial white papers that basically define the scope of that and create an opportunity for people to start being more forward-thinking rather than complacent.
I believe that you can’t hold a good idea down. And the fact that it’s so popular in Europe for consumers to be involved with structured products reminds me of my visit to Hong Kong in 1990. I remember walking through shopping malls and seeing two out of three people with cell phones pressed to their ears. And that was a time when, in the U.S., not nearly as many people were using cell phones. I think the same thing is likely to happen here with structured products, and I think it’s likely that they’re going to be highly successful in the consumer market and cause some genuine market realignment.It’s a very elegant analogy, the cell phone technology. We are, after all, talking about the mainstreaming of useful technology. What’s the best and most efficient way to deliver that technology to the market? In our case, it should be delivered through channels most familiar to investors. A structured note? Maybe not. But in the form of mutual funds or closed end funds or an insurance product – you have the opportunity to deliver this value proposition to investors without having to discuss the complexities of how the products work. And once we crack that code, then the sky is the limit in terms of the potential for everyone involved.
Well, again, cracking that code is, to a large extent, going to be solved through education and innovative communications strategies. I want to ask you about another segment of the market that also has educational needs, and that’s the regulators. As you are aware, here in Massachusetts where I live we saw the securities regulator announce an inquiry into the structured products business. Not based upon any complaints, not based upon any dissatisfied investors, but just seemingly for the sake of learning about the business. How do you view that, and how do you see the imperative, if it is one in your view, to educate regulators?Extremely important. As structured products go more mainstream, it’s inevitable that the regulators have some catching up to do. Maybe I’m in the minority when I welcome regulatory scrutiny. Sales practices are sound, and all firms, by and large, follow the FINRA guidelines. It’s part of the inevitable growth of the industry. The Structured Products Association spends a good bit of time interacting with regulators to make sure that they’re aware of how they market is progressing and how it’s growing, and we’re very comfortable with the sales practices. There have been almost no customer complaints, there’s no lawsuits have filed on structured products, there’s no regulatory actions that have been taken. But we don’t want to be complacent about it. We want to be forward-thinking.
Vacuum tubes had their defenders for years. And still do among audiophiles.
But let me ask you a question that’s personal in nature. And that is, if I could convey to you a magic wand, and by waving this magic wand you could make any two changes at all — this is the power of God I’m describing now — any two changes instantly in the world of financial services, what would they be?I’d like to see the world have full transparency in terms of the levels of fees versus the value of the instrument that’s being promoted. I’d love to see the financial services industry– we talk about the ideal of best efforts for the client, fiduciary responsibility to the client. We see structured products starting to move in that direction, I’d like to see the entire financial service industry be driven more by the value of the investments and what they bring to the table, as opposed to being driven by fees. So more transparency and better value for investors. And I’d also like to see a little bit less confusion in the channel. There are so many products that are being offered, there’s more mutual funds being offered than there are stocks on the New York Stock Exchange. Not really waving a wand for consolidation, but some sort of sanity in the channel– to avoid investor confusion.
Good answer. Next personal question, Keith, would be this: if you were not the founder and chairman of the Structured Products Association, but instead could have any other occupation in any other field of any type, what would you choose to be?One of my great experiences so far is having published a couple of novels. And having had the feedback from those who’ve read the book — I love being able to communicate with someone far off, and having that energy come back to you in some way. So I’d probably consider being a writer full time, I’m very fortunate enough, having been the chairman of the Structured Products Association for the last four years, to have had that opportunity and to be able to communicate with regulators and investors, advisors, and great numbers of people that I otherwise would not have had in my life. So that’s been a privilege and an honor.
Good answer. I’ve told you before how much I am in awe of writers in general, and having two published novels is really something. So my congratulations. Last question. Although you’re a long way from retirement, I’d like you to imagine your own retirement in its most idealized, perfect fashion. Where will you be and what will you be doing?We are so focused on the world of day to day that we don’t find the luxury of being able to daydream often of what we’ll be 20 years from now, let alone one or two years from now. In my retirement, I imagine having an opportunity to- travel the world in a way we can’t even possibly imagine in our working years. I’d have a thousand places on the list, but I’d also spend time with family and writing. Perhaps writing more full time, writing books, both fiction and non-fiction and just explore the creative process that we have to suppress so many times during our career. Perhaps a personal investment in structured products will help me realize such lofty goals. (Laughs.)
Keith, those are great answers. I want to thank you so much for taking so much time for this interview, it’s been fantastic. I can’t wait to see it published, and I can’t wait to share it with all of our readers.The pleasure’s mine, David. Thank you for the privilege of participating.
David Macchia runs Wealth2K, www.wealth2k.com, a financial-services media and marketing company focused on retirement income.