Frederick Wright, CIO at Smith & Howard Wealth Management, says structured products can reduce risk

By Emma Trincal

New York, Aug. 31 - Frederick S. Wright IV, partner and chief investment officer at Atlanta-based Smith & Howard Wealth Management, said on his web site that his "most rewarding work is in helping reduce risk in client portfolios."

Wright told Prospect News that one of the purposes of structured investments is to do just that. The independent financial adviser, who holds the Chartered Financial Analyst designation, has been in practice since 1998. He bought his first structured product in 1999.

Asked whether his first foray into structured investments originated from a client's inquiry, he said, "It was my own idea. I came across structured products because Bank One was offering a structured CD at the time. The market was frothy back then, and it was a good time to take some risk off the table."

Reducing risk

Wright said that the CD was also helpful because during that period of high volatility, clients still wanted exposure to stocks, in particular internet stocks, but at the same time expressed the desire to reduce their downside risk.

"I bought two structured CDs back then, which were both five-year CDs. One was tied to the market, and the other one was linked to a basket of internet stocks," he said.

"They were both Bank One CDs. I bought them through Charles Schwab."

Wright's interest in structured products as a tool to meet specific needs continued to grow from there to the extent that such securities account today for 10% of his clients' investments.

Smith & Howard has more than $700 million of assets under management invested on the behalf of its clients, which are individual investors and high-net-worth individuals including their families.

"My allocation to structured products is a combination of structured notes and structured CDs," Wright said. "Most of the new paper that we have, though, are notes because it has become so difficult to get good terms on CDs with the interest rates so low. Back then, you could get great CDs. But not anymore."

Hedged equities

Structured products are fully integrated into the portfolio as part of a discipline developed by the firm. Most of the time the products are used defensively, primarily to reduce risk and also to get exposure to a certain asset class.

"We created a new asset class that we call hedged equities, which we add to others such as equities, bond, cash, etc. What we typically do is allocate 10% of the portfolio to hedged equities and we would put, for instance, buffered notes in that category," Wright said.

Why "hedged" equities? Simply, Wright explained, because the goal of this investment approach is to maximize returns while reducing downside risk. Hence the choice of either buffered notes, which provide some limited downside protection, or the use of fully protected structures, which guarantee 100% of the principal back at maturity subject to the issuer's credit risk.

Tough buffers

But that's when picking the right securities becomes challenging as buffers have been shrinking in size over the past couple of years, Wright said, adding that this trend is more visible in the United States than it is abroad, for instance in the United Kingdom.

"Typically we look at two-year maturities, sometimes less, for instance in the 13 to 18 month range. We use the S&P 500 as the underlier. We like plain vanilla deals," he said.

"The tough part is getting the right buffer. We look at as big a buffer we can get, in the 10% to 15% range. We'd like 20%, 25%, but it's hard to find nowadays. Most of the time, you're not going to get more than 10%. It was not always the case. In the end of 2008, at the height of the financial crisis when volatility was really high, we bought notes with a 20% buffer or more. But now, 10% is standard."

Since Wright wants a comfortable level of protection without sacrificing too much of the upside, he tends to avoid leverage.

"When you elect not to have leverage, you get a higher cap, and that's what we're looking for," he said.

Hedging the downside

The way structured products help a client's portfolio, Wright said, is by "hedging risk."

"By carving off 5% to 10% from the equity, investors manage to reduce volatility in their portfolio because a certain amount of principal is protected," he said.

"When we achieve some downside protection, we construct a portfolio that has less volatility, and that's one of our main goals," he added.

After looking at broad commodity indexes without finding the adequate products, Wright said that his next move may be to look for oil-linked notes or products "close to oil."

Access to a view

Wright said that structured products are valuable tools for investors seeking to gain access to other asset classes. He used structured notes, for instance, to get exposure to currencies and commodities.

"We bought exposure to natural gas through an MLP [master limited partnership] note but also a note linked to the price of gas. At the time, gas was very cheap and we thought it was the right time," he said.

Overall, structured products can be used as an alternative to a direct investment, he said, or as part of the asset-allocation process. In both cases, reducing the risk exposure of a portfolio or playing a particular market trend are some of the potential benefits, he said.

For Smith & Howard Wealth Management, the experience with structured products has been a positive one, Wright said.

"We got there at the right time. In 1999, when we first used them, it was the peak of the internet bubble. Our clients still wanted exposure to internet stocks, but they didn't want such a high level of risk. We got off to a very good start," he said.

Wright continued to buy more structured products in 2007 until late 2009. "The timing was great. Our clients held up very well because of a principal protection or a nice buffer," he said.

Clients, though, need to be educated on structured products before making investment decisions.

"We have to talk to them and make sure they understand the products. It's an ongoing conversation," said Wright. "But overall, clients tend to be satisfied so far."

Careful selection process

Wright carefully selects the securities, eliminating certain categories in which he does not have any inclination to buy, such as reverse convertibles.

"I'm one of these people who doesn't do reverse convertibles," he said.

"It's just that our firm doesn't follow individual stocks, so it doesn't make sense for us. It would make more sense for a broker. We're more of an asset class manager. We buy indexes or mutual funds. In addition to that, reverse convertibles are more risky."

When Wright began to include structured investments in his clients' portfolios, Wall Street firms and structuring desks used to call him all the time, he said.

"We've got them under control now, and they provide us with regular offerings but on a reasonable basis: periodically, monthly and not all the time," he said.

He said that structuring desks - especially the wirehouses - do a good job at reaching out to advisers. He declined to name the firms he conducts business with.

"Sometimes a structurer at a desk would call us and offer to meet. Other times, they will invite us to seminars to educate us and to get [registered investment advisers] more familiar with those investments," Wright said.

Information between advisory firms and advisers circulates as well, allowing investment professionals to share the latest developments in the industry, he said.

"I know some other colleagues at other firms who have seen what we did and found those products very interesting. They like hearing about it, and some are considering them," he said.

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