Investors seek structured products amid turmoil, advisor says; Morgan Stanley offers twist on commodities

By Kenneth Lim

Boston, March 13 - The tumultuous markets these days give structured products added importance as investors take a closer look at risk, said investment advisor J. Scott Miller Sr. of Blue Bell Private Wealth Management LLC.

"I believe that this market environment is actually a benefit to the issuance of structured notes and structured products, especially for the high net worth individual," Miller said. "Don't forget that structured products give them access to many risk-reward or risk-adjusted types of investments, and it allows people to pick a particular strategy or pick a note based on a certain strategy. We've seen bearish notes, we've seen a couple of gold issues and oil issues."

The past few weeks have been turbulent for markets. The U.S. stock market, in particular the financial sector, has taken a beating amid troubles on the economic and credit fronts. The U.S. dollar has been falling, while oil and gold prices have been climbing.

"Depending on what you invested in, if you bought a reverse convertible that was linked to a financial stock, that's a lot of pain," Miller said. "Because in a reverse convertible linked to a single stock, when the protection is breached the investors in effect own the stock."

"I would imagine, on the reverse convertibles, if there's any blow-up from what's happening in the markets, there's where the blow-up would be," he said.

Need for education

Retail investors are becoming a bigger factor in the current demand for structured products, Miller said, especially in reverse convertibles. That increases the need for better investor education, he added.

"We have no problems with reverse convertibles," he said. "We just have concerns about some of the selling practices of some brokers who sell the coupon without explaining the risks."

Miller said portfolios managed by his firm have been more defensive for some time as investors looked for better protection on the downside.

"What we're seeing is that people are so concerned now about risk-adjusted returns," Miller said. "One of our high net worth clients today, we just spoke to him and he wanted to make sure that he was somewhat protected on the downside."

Buffered notes work 'very well'

Blue Bell has found a valuable instrument in buffered enhanced-return notes, Miller said. Such products have partial protection on the principal and accelerated participation on the underlying asset's upside.

"These have worked very well in this environment," Miller said. "If the market falls by 10%, for example, you still get all of your money back."

A $100,000 investment in a buffered note linked to the S&P 500 index, for example, will return the full principal if the index falls 10% after a year and the buffer protection is 10%. But an investor who bought directly into the SPDR S&P 500 exchange traded fund would get back only $90,000. If all that money is reinvested in the same instrument, and the index falls another 10% the next year, the structured investment remains unchanged while the direct investment would fall to $81,000. And if the index rises 10% in the third year, the structured investor gets more than the direct investor, Miller noted.

"Buffered notes are by far our largest holding," Miller said. "We've been doing these buffers for a year now. We have 15 different positions based on the S&P 500 that are buffered from 5% to 15%, and based on those 15 issues, we have only six where the buffer levels have been breached. So there's a lot of protection still on our portfolio."

The buffered notes also help to hedge against the downside for contingent protected digital notes at Blue Bell, Miller said.

Building a portfolio

A week ago, Blue Bell got into some six-month contingent protected notes for its clients. If the S&P 500 stays the same or moves upward, investors make a 10.5% return for that six-month term, or 21% annualized.

"We think that for an unchanged market, 10.5% or 21% annualized is a pretty good return," Miller said.

Those contingent protected notes only protect the principal if the underlying never closes lower by 20% or more. To mitigate that risk, Blue Bell also invested in products with a 10% buffer on the downside, Miller said.

The goal is to structure portfolios to cushion against unexpected changes by using varying maturities, returns and protection levels, he explained.

"Don't forget that it's all part of a managed portfolio," Miller said. "The average stock brokers you know they sell to clients notes when they have money, so they might own one or two or three issues, and we think that's a little dangerous because that's a point to point investment...Point to point is problematic if you don't have, in our view, a way to manage the risks."

Svensk's banks versus financials

Another recent product that seems to have benefited from the recent turmoil was AB Svensk Exportkredit's 0% outperformance notes tied to a long position in the S&P 500 Banks index and a short position in the S&P Financial Select Sector index via Goldman, Sachs & Co.

The notes, which are due Aug. 31, 2009, will pay par plus the difference between the two index returns if the long index outperforms the short index. The payout at maturity will be par minus the difference between the two index returns if the long index underperforms the short index.

"The financials have really gotten hit hard," Miller said. "That market call thus far appears to have been a really good call. When you see some of the stocks, like Bear Stearns, it looks like it was a really good call. But that's a different type of product. You can potentially make money even when the market is down."

Morgan Stanley links to commodities

Morgan Stanley is offering 0% buffered leveraged securities due March 2013 linked to commodities, but with a twist.

The basket consists of the Dow Jones-AIG Commodity index with a 60% weight, natural gas with an 8% weight, primary aluminum and CBOT soybeans, each with a 7% weight and NYBOT cotton No. 2, gold and NYBOT sugar, each with a 6% weight.

Instead of taking a straight difference of the underlying commodity and index prices, the securities will measure the basket performance based on the difference between the basked commodity prices and the estimated forward prices of the underlying commodities.

If the final basket level increases over the initial level, the payout will be par plus any gain on the basket multiplied by a leverage factor of 130% to 145%. The exact upside leverage will be determined at pricing.

If the basket declines by 15% or less, the payout will be par. Investors will lose 1% for every 1% the basket declines beyond 15%, but will not receive less than $150.

The notes are expected to price in March.

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