For some advisers, structured notes part of the alternative investment concept, bucket

By Emma Trincal

New York, March 6 - More financial advisers recognize that structured products fall into the definition of alternative investments. What is more difficult for them is to decide how to allocate the notes within the overall portfolio, sources said.

On the alternative investments designation, Steve Doucette, financial adviser at Proctor Financial, said: "It has worked to bring the correlation of our portfolio down very much.

"Anytime you start looking at something else rather than long only, especially with an equity underlying, you are in an alternative investment asset class," he said.

Alternative investments fall under a variety of definitions as the concept has evolved through the years, becoming broader, sources noted.

Correlation

Originally, alternative investments were the asset classes that did not belong to the three traditional ones, such as cash, stocks and fixed income, said Carl Kunhardt, wealth adviser at Quest Capital Management.

Kunhardt said that that the non-correlation with other asset classes remains a valid definition.

"For us, alternatives are an asset class that offers little correlation with cash, fixed-income and equity, the traditional asset classes. It may include commodities or futures," Kunhardt said.

"Managed futures, for instance, by itself is very aggressive. But returns are not correlated to the other three asset classes, so you can actually lower the volatility of the portfolio without hurting the return.

"We think structured products offer the same characteristics: it's an alternative strategy tied to a traditional asset class but that offers something else, like, for instance, risk mitigation or return enhancement."

Dampening volatility

Kunhardt said that alternative investments, contrary to the myth, are not necessarily riskier since they can often reduce volatility.

In his practice, Kunhardt uses structured products in that mindset.

"When you enhance return, you add risk to the portfolio. We tend to stay away from it. Rather, we use structured products to mitigate risk.

"I'm not looking to add return. I'm looking to lower risk without dragging down the return," he noted.

In some instances, alternative investments designate a category of investments available only to the accredited investor and not to retail.

In this case, access is what a minority of wealthier investors try to obtain through hedge funds or private equity by paying higher fees. The ultimate goal is to generate "alpha" or excess return.

Complexity

"I do consider structured products to be alternative investments not because it's an alternative asset class but because it's an alternative way of getting exposure to indexes," Keith Styrcula, chairman of the Structured Products Association, told Prospect News.

While not always risky, alternative investments tend to be inherently more complex than traditional investments.

"The fact that it's kind of complicated suggests that it should not be treated like a mainstream [exchange-traded fund] or stock. I think of alternative investments as investments that require some level of sophistication," said Styrcula.

"But to me, the definition is not based on who can or cannot invest in it. It's not a classification by investor type, like retail versus accredited investor.

"It's more a classification based on the accessibility of the asset class.

"Ten or 15 years ago, alternative investments meant asset classes that were hard to access, like commodities, real estate. They were hard to access because there was little liquidity.

"But then you had the exponential growth of ETFs, which has facilitated access to those asset classes. There are so many new asset classes and so many ways to get exposure.

"So I think now, what makes a structured product similar to an alternative investment is the level of complexity of the instrument.

"You can replace a stock index with a leveraged buffered and capped note and it's going to be more complicated as an instrument. That's where the concept of alternative plays out to me," Styrcula said.

Beta

For many institutional investors and hedge fund investors, an alternative investment is supposed to produce alpha.

Styrcula said that such narrow definition of alternative investing probably did not apply to the derivatives technology used in the structuring of notes.

"It's not alpha. I think structured investments are beta," he said.

"And, by the way, almost all hedge funds produce leveraged beta.

"I think a better way to define alternative investments now would be non-traditional investments. I would call an ETF a non-traditional investment even if they are mainstream. And I would also put structured investments in that category," he stated.

A market participant agreed that alpha is not what defines a structured product.

"If you define alternative as generating alpha, I don't see structured notes as delivering alpha.

"There are exceptions. You could be getting alpha from a structure in which you're selling puts that are expensive or in some currency basket packages.

"But to me, I would consider alpha more like a long/short strategy," he said.

Just because structured products are not designed to accomplish what a long/short equity hedge fund would do does not mean they don't offer many benefits, the market participant said.

"There are many advantages: scalability; getting everything tailor-made; access; and the packaging. You don't have to do it yourself. It mimics the options, but it's a lot cleaner," he said.

Allocation

Allocating structured investments to the right bucket and in the appropriate amount is not always a simple task.

Kunhardt said that in general financial advisers do not allocate enough to alternative investments.

"Look at the endowments and pension plans. Up to 40% or 50% goes to alternative. And they generate the best returns," he said.

"As a planner, you should have higher allocations to alternatives."

Kunhardt allocates 10% to 20% of his portfolio to alternative investments.

"I would take, for instance, a 5% from the fixed-income bucket and put it into structured notes.

"Another 5% would be taken out of the equity bucket and could go into equity long/short for instance," he said.

Kunhardt said he uses structured notes mostly as a risk management tool. His approach makes the allocation easier to determine, as a rule.

"Structured notes in my investment style take the place of fixed-income. It's a fixed-income replacement," Kunhardt noted.

"What is a fixed-income allocation? It's something that mitigates risk and gives you income.

"That's what I try to accomplish with structured notes. One, I get less volatility. Two, I'm buying a bond with the potential of getting equity-like returns, that's what I am looking for a structured note to do," he added.

Kunhardt can easily use structured notes as a replacement for fixed-income given his target return of 8.5% for the overall portfolio.

"It's not shooting for the moon. I'm conservative. If I can lower the 11 or 12 standard deviation to 9 without dragging down my return, that's what want.

Kunhardt said that he uses buffers. He also seeks full capital preservation with the caveat that he will not give up too much liquidity to get the full protection.

"I won't get locked in for 20 years for the principal protection for instance. That would be a lot to give up," he said.

Styrcula said, "It's very difficult to squeeze structured investments into a bucket" because it's not clear whether it should go to traditional asset class buckets or to the alternative investment allocation.

Underlying asset class

"Structured notes should be allocated according to the asset class," the market participant said.

"An equity-linked note should go to equity, a commodity note to commodity. [It's that simple.]"

The market participant said that he did not believe structured notes should belong to an alternative investment bucket because investors do not invest in them for the liquidity premium as hedge fund or private equity investors do.

"Alternative investments such as hedge funds, private equity are just not very liquid investments. You have to commit capital.

"It's different with structured notes. Notes are liquid.

"I know, some people think they're not. But let's not confuse liquidity and [...] I don't like the mark," he stated.

"A hedge fund with a six-month lock-up, that's what should go into your 5% alternative investment bucket," he said.

Suzi Hampson, structured products analyst at Future Value Consultants said, "It's hard to put structured products in one group together. It's such a wide range of different things.

"You can link a structured product to anything. A lot of the time, you take equity risk and make returns on equity, so an equity-linked note for instance should probably be allocated to equity bucket rather than anything else," she said.

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