Increase returns with alternative investments

Key Points

Q. Trying to increase returns while protecting what I have accumulated has become more difficult as my assets grow in size. I am looking to diversify into areas considered alternative investments such as commodities, foreign currencies, developing nations' economies, etc., but I am nervous about the losses I may incur in areas I don't really understand. I have heard that structured products might allow me to participate in these types of investments, but while protecting me on the downside. Could you please explain how these investments work?

A. We agree with you that as your assets grow you should consider expanding the asset classes that you invest into. Theoretically, this lowers your risk while increasing the expected rate of return. This is accomplished by reducing the overall volatility of a portfolio. It is our conclusion that structured products do offer a viable solution to investing in hard-to-reach assets. Although complex portfolio construction can be challenging, the resulting customized fit of a structured product can hold singular value for those like yourself who have sophisticated needs.

Structured products are created from strong cloth, combining elements of stocks, bonds, and options. These investments may be attractive to many affluent investors, such as ophthalmologists, due to the versatility they can offer compared with more traditional investments.

Skilled tailors and sophisticated advisors know the truth: complex construction can be challenging-but the resulting customized fit may be worth the time and effort, because it holds singular value for those with sophisticated needs.

What are structured products?

Despite increasing public exposure, structured products as a concept has not yet reached household-name status. But their 33% increase in sales (up to $64 billion) in 2006, with approximately half of those sales being driven by the retail sector, gives reason to expect they may become more and more familiar in the future.

In its simplest form, a structured product is an investment vehicle that derives its value from the performance of one or more underlying assets. It usually has two components: a fixed income note and a derivative-a combination that gives it a unique mix of traits native to stocks, bonds, and options. The fixed income note is typically a zero-coupon bond (or insured C.D.) with a fixed maturity, which helps provide full or partial protection of the invested principal. The derivative component provides a variable payout linked to the performance of an underlying asset, such as a market index, a basket of commodities, or a specific group of securities.

The derivative component of structured products and the potential loss of the principal for many such products may make them unsuitable for investors seeking alternatives to traditional debt securities. While structured products are similar to debt securities, the profit and loss potential of many of them more closely resembles the risks of holding option contracts, especially for products where the principal invested is at risk from market movements in the referenced security.

Structured products are commonly created and packaged by investment banks and sold to investors through financial advisors. However, they have slowly begun to show up on national securities exchanges for trade on the secondary market, though investors should be aware that a secondary market is not guaranteed and may not exist. Trading of structured products is still relatively thin on these exchanges, so investors shouldn't assume they can easily sell one prior to maturity and receive full market value. If liquidated prior to maturity, they may be worth less than the purchase amount or face value because its value is dependent upon fluctuations in the underlying basket and the performance of the specified underlying instruments. Principal protection for many of these products takes effect only at maturity, not before.

The benefits

Structured products that have principal protection features potentially offer an opportunity for greater returns than bonds or money market accounts, but may involve less risk to principal than an outright investment in equities. That's a feature that can make them an attractive option for investors seeking to enhance their returns without too much exposure on the downside.