US regulators are tackling the way advisers present and sell structured products. Pablo Conde asks what changes they face.
Until the mid-1990s, structured products were only available to ultra high-net-worth Americans via a handful of private banking institutions. Today there are more than 68 manufacturers and issuers and hundreds of brokerage and advisory firms marketing structured products to retail investors. The industry has grown to the size where its fortunes are intertwined with the wider economy and where any problems it suffers can quickly at least appear to be the problems of the nation. Not surprisingly, therefore, the effects of the collapse of Lehman Brothers and the financial crisis have focused the attention of US regulatory agencies on the way retail structured products are sold.
This view is not always reflected among the advisers that sell - or advise on - the products. Scott Jurczyk, principal and MD at Financial Solutions Advisory Group, says: "For us, regulation that increases disclosure is important to add transparency, but I do not think you can solve the problems by over-regulating," he says. "Over-regulation will dry up liquidity. With our clients, it is nice not to have to have a 5 million [dollar] portfolio in order to access these institutional type investments. If regulators decide to start putting rules that limit what clients can have, we think that's bad, but if the focus is on disclosure then we think it is good."
Jurczyk said the regulatory push is targeting investment banks and brokers that receive 'commissions' and don't do their job on compliance and disclosure: "I currently don't see how that will impact our business as a fee-only adviser," he adds. "We don't issue structured products and we do not get commission for selling them or by putting them in a client's portfolio. Unless the SEC decides that only qualified investors should be allowed to purchase the notes then I am hopeful that new regulations will not change the way that we do business."
Scott Miller, managing partner at Blue Bell Private Wealth Management, another fee-only registered investment adviser, RIA, in Pennsylvania, stresses the difference between fee- and commission-based brokers: "There's a big difference in this country between people that are selling and earning a commission and the people that are investing in these products because they believe it is the right proposition for their clients," he says. "We provide discretionary investment services as a fund manager does as opposed to a broker that works for an investment bank, which earn a commission when they sell these products to their clients."
Alan Dalewitz, a senior vice president at Herbert J Sims & Co, agrees: "No one wants to be in a situation where a bad investment ruins a relationship," he explains. "We have been fairly careful with our sales approach. Obviously, each broker is free to recommend or not, so in that respect I think it all goes down to the suitability of the product to the client."
Halliday Financial executive vice president and director of structured products Tom Livingstone defends the commission-based adviser. "I am fee and commission based," he says. "We have a pretty good understanding of where a client should be and when we tell them that we're going to be paid for this we rarely get pushed back." Livingstone says it is often in a client's interest to invest in a commission-paying product rather than pay a fee to his firm on the entire account. "...He will pay me over the course of five years, depending on what type of fee structure we have, 1.5%-2% to manage his account. So over the course of five years he'll be paying me 10%, whereas if I did a structured CD or note he will pay maybe 2.5% over the entire five-year period." He concedes, "Sometimes it works better for the client and sometimes for you, but you really have to do your homework before making these recommendations."
Like Jurczyk and Miller, Dalewitz does not see regulatory changes affecting the way he markets structured products: "Our firm has a focus on high-yield investments and as a result of that we are quite aware of what the hurdles are, and we explain all the risks to our client base," he says. "We put the offering statement physically or electronically in the individual hands and then have a discussion on what is the strategy of the product, making sure you explain what the positives are but also what the negatives are."
Reversing without a mirror?
The adviser's self-regulatory body, Financial Industry Regulatory Authority (Finra), recently highlighted a mis-selling case in which an elderly couple lost most of their money in an investment portfolio largely consisting of reverse convertibles. "It appears that they were buying reverse convertibles exclusively for yield, but did not put much attention on the underlying risk taking on individual securities," says Miller. "For that reason, we do not believe in using only one issuer. We believe in using multiple issuers, so that you spread out the credit default risk of the provider. We also limit the percentage of any one structured product to a 3% level, because we do not think there should be a concentration of maturity dates either. We look at the risk profile of the client and in some cases a client that is more risk averse but wants to be in the equity market might have a higher percentage of structured products in their portfolio because of the downside protection."
Like many other financial innovations created by Wall Street, "These products were a great idea," adds Livingstone. "But the sales teams of a number of firms sold them improperly and they were ultimately sold to investors that they were not suitable for. These are great products for a number of circumstances but they're dangerous in the wrong hands, as people can lose a lot of money, as the evidence has recently proven."
Tim Fortier, a managing partner at Structured Products Advisors, was among the early users of reverse convertibles in the US: "Over the years I became concerned because I think the industry thought more about the volume of new issuance rather than the quality," he says. "The problem is that most investors did not understand the risk involved and brokers sold them incorrectly as yield- enhancing products when they actually are equity derivatives and are exposed to performance risk."
Because investors in reverse convertibles cannot remove the embedded equity-like risk, Fortier says the industry should talk more about 'proper' asset allocation: "Fortunately, because of the systematised process we use in selecting these securities and because we do spend considerable time in the front end educating investors, we have had very few problems. But it is very important to address the situation, because as we have seen if the industry does not address the issues that come up then the media will grab them and put them under a bad light."
Halliday's Livingstone says the firm also uses a 'fairly exhaustive' process to discover client needs: "Even if we identify a product that is suitable for a particular client or meets his or her expectations, the client literally has to sign off that he/she understands what these products are, how they work, what is the associated risk and if they do not understand them, they are not going to be allowed to invest," he stresses.
"We assess allocation on individual client needs because some of the retirees are looking for income but they are also looking for protection on their investments," says Tim Mingo, president at Florida-based Regent Investment Adviser. He says reverse convertibles were sold to older and more conservative types of investor, including retirees who wanted their savings protected, not gambled; and that most fee-only RIAs would not bet clients' money for a fad.
According to Herbert J Sims & Co's Dalewitz, "[In respect of] reverse convertibles, I have always done it on the basis that if an individual is going to buy a reverse convertible he should be able to live with that particular security at the price he's given." He explains the products as bought puts: "But because of the barriers, and knowing what the markets do over time, you have to be prepared to understand your exposure."
"At one point they were talking about ...the client that buys these having to be approved for option trading. In the US, we have options trading and also levels of option suitability. These products are, let's face it, manufactured by using options," says Blue Bell's Miller. "This is where I agree with the regulator, because, unfortunately, a lot of people who ended up with structured products in their accounts, which were purchased by a commission broker, did not know about the downside scenarios when the investment blew up."
Education or regulation?
"A greater amount of education from the get-go would have prevented some of the discussion we are having now," says Fortier. "Offering a fat coupon without making sure all the elements of the product were right was a mistake. Too much emphasis has been placed on the yield aspect and not enough focus has been placed on the equity characteristics. Some of these products were never properly explained." Fortier believes the main focus of education should be the application of the strategies. "Investors should be considering credit risks, market risks, sector risks and individual security risk. If you start by thinking about risk first, then it is not only much easier to manage expectations but it is likely that one's investment results will also improve" he says.
Regent Investment Advisors' Mingo says advisers are looking a lot more carefully and closely now: "A lot of structured products are good products, but we do not want to have the regulatory issues drive our decision of selling, or not selling, what products," he says. "We are concerned about the regulatory climate. There is a lot of ambiguity there," he says. "We do not want to be in a position of recommending something that we think is going to make an addition in our client's portfolio and earn him some money just to be told later on that it was not a good investment decision by the regulatory agency. What we want is clear guidance of what we should be doing to make sure we're satisfying the concern of protecting clients from certain products in the marketplace."
It does not need to be complicated, he says: "This could be solved with an industry-wide template of some sort of sample model portfolio, but then you have to take into account that every client situation is different."
Some of the advisers interviewed mentioned DB, Goldman Sachs, Credit Suisse, JPMorgan and Barclays as issuers providing good educational materials about structured products, and most agreed with the Finra proposals to add a section on structured products within the RIA exams: "That is the first place they should start, because that is requiring of anybody entering the market an understanding of exactly what it is they are trying to sell," says Miller.
There is some concern in the advisory community that some firms might take a draconian view and stop selling structured products altogether if the regulatory environment is too tight. However, others said the use of structured products to achieve leverage will return following recent good market performance, although most advisers use structured products to attain principal protection.
Finally, though, in a fairly common off-the-record remark, some advisers think it is not just their peers who need a better understanding of the structured products market. "The regulator needs to understand structured products before any further regulatory move," concluded one.
