Though not as popular as they once were, alternative investing vehicles such as ETFs and PPNs still have a role to play
Were you filled with an overwhelming sense of dread after the Dow Jones Industrial Average soared past 12,000 this month?
If it's a crash you fear, then perhaps it's time to read up on alternatives to stocks. Retail structured products, or RSPs, are investments that give a return using a calculation based on stocks, commodities, or other assets. They can also often have hedging strategies built right into the structure, which helps to reduce an investor's risk, and may offer guaranteed protection for your initial investment.
RSPs have had a bad rap lately, mainly because of poor sales as a result of the fallout from the income-trust mania last year. But there is more to the RSP world than funds of trusts. Recent signs of life for RSPs emerged this fall, following a dry summer, which saw just $220-million in sales from eight capital trust and limited partnership offerings, according to the Investment Industry Association of Canada.
Though the body hasn't released statistics for the third quarter, Thomson Financial data shows 30 deals brought in about $578-million.
That brings the year-to-date total to $3.88-billion, which is music to the ears of Scott Smith, managing director of equity capital markets and head of syndication at CIBC World Markets, the largest Canadian dealer of RSPs.
"Things have turned around," said Mr. Smith, adding that his shop just closed a deal for $290-million.
He predicts a good November, based on current activity.
The summer was particularly bad, Mr. Smith added. Worse still is this year's comparison to last year's $9.04-billion raised in 83 structured-product financings nationwide, and the $9.16-billion raised the year before that, according to data from CIBC World Markets.
"We've seen tremendous markets last year and the previous year. This year has been a slow year. Overall year-to-date issuance is down 50 per cent," Mr. Smith said.
Yet the brokerage continues to generate money from selling retail structured products because for many investors, they have provide a service they couldn't otherwise access, said Ron Mitchell, managing director of equity capital markets who specializes in retail structured products at CIBC World Markets Inc.
How RSPs work
Common examples of RSPs include exchange traded funds, which trade like a stock on an exchange but whose value is based on an underlying index, commodity, or group of assets. The performance of these funds varies widely, depending what they're based upon.
When investors buy RSPs, "it gives them access to things they can't get themselves or do themselves," Mr. Mitchell said.
Buyers are typically investors who hold stocks and are "buying some expertise out there so you don't have to do all the legwork," added Mr. Smith. "You're paying [the seller] a fee to do that for you."
To earn these fees, the street has been focused on developing many areas of retail structured products, including resource limited partnerships, Mr. Smith said.
These are investments that take advantage of the Canadian government's incentives to encourage investors to finance exploration for resources.
In the mining as well as the oil and gas sectors, companies sell flow-through shares that share in the tax deduction for these exploration and development expenses.
By putting pools of funds together, the investment managers can form a limited partnership to flow the tax through to the partners, he said, which helps diversify risk. The street sold $900-million of these types of RSPs last year, and it's up to $1.2-billion already for 2006, Mr. Smith added.
Brokerages are also seeing a return of split-share deals, which involve building a portfolio of stocks, (for example bank and insurance companies) that goes into a special purpose corporation offering two classes of securities. The dividend goes to one class of investors, and the other has a leveraged exposure to the portfolio.
Another type of RSPs are principal-protected notes, which offer an investor potential returns based on the performance of an underlying investment and a guarantee that, upon maturity, the investor will receive no less than what he or she put in. PPNs include market-linked GICs, and linked-notes.
Understand the legalese
Before jumping into these complex investments, however, investors should take the time to carefully read the legalese, particularly with principal-protected notes, said Tim Baron, a partner at Davies Ward Phillips & Vineberg LLP.
Many RSPs are being created without the expense of a prospectus, and instead offer a considerably less-detailed offering memorandum that doesn't need to be cleared with regulators, said Mr. Baron, who is a part of the structured finance group at Davies.
This has caught the attention of Canadian Securities Administrators, which, on July 7, 2006, issued a notice of its concerns. In particular, the notice states the CSA's concern that "investors are not getting sufficient disclosure to allow them to make an informed investment decision. They are not getting sufficient disclosure about how PPNs are structured, how they work, and the fees and investment risks associated with them."
The CSA also said that many presentations were overly promotional, and seemed to provide access to "complex alternative investment products like hedge funds, funds of funds, or managed futures, without the general protections Canadian securities laws provide or sufficient disclosure to permit an investor to make an informed investment decision."
Still a compelling case
Mr. Baron said that this doesn't mean alternative investments, and in particular PPNs, are a bad choice.
However, he says it's important to be clear on the details, particularly about who exactly is offering the product.
"You can feel more confident when the Merrill Lynches and the BMOs of the world are offering these products, than when the smaller entities are," he said.
Another crucial factor, Mr. Baron said, is that investors should understand how the return is calculated in all situations, not only in favourable markets.
In some cases, when a return on an RSP is linked to a volatile investment, for every $10 put in by the investor, $5 might be used in another security that provides the guaranteed return, such as a zero-coupon bond or insurance product.
If the volatile investment does indeed do poorly, the brokerage might take money out to apply it to the guaranteed protection. If the volatile investment does well, they may apply more money to the underlying asset.
"The real risk is you invest your $10 and it sits there and you get $10 back," Mr. Baron said. "People should understand that when these are guaranteed protected by the banks, it doesn't mean the bank is going to step up and protect you. It protects you, but it protects you at the risk of not getting very much exposure to the underlying asset."
Such details are generally in a prospectus or offering memorandum, Mr. Baron said, but sometimes the legal language makes it difficult for investors to understand.
It's also important to realize that if you want to sell your principal-protected notes, there often is no secondary market, and there can be a penalty for pulling out early, he said.
Despite the concerns with some types of RSPs, Mr. Baron believes they will continue to be in demand.
As to why sales aren't humming right now, he says, "the reason for that is the same reason retail investors are not looking intently at hedge funds and other types of alternative investments right now: When returns are very high in the stock market, why go to the alternative investments?"
As stock markets come off their highs in the future, he says, demand areas for RSPs may include those that are popular in the institutional market, including more obscure areas such as credit derivative products and mortgage-backed securities.
Theresa Ebden is an associate producer for Report on Business Television.
A structured primer
What they are
Retail structured products, or RSPs, are investments that give a return using a calculation based on stocks, commodities, or other assets.
Examples of RSPs
Exchange traded funds (ETFs) trade like a stock on an exchange but their value is based on an underlying index, commodity, or group of assets.
Resource limited partnerships take advantage of the Canadian government's incentives to encourage investors to finance exploration for resources.
Split-share deals involve building a portfolio of stocks that goes into a special purpose corporation offering two classes of securities. The dividend goes to one class of investors, while the other class has a leveraged exposure to the portfolio.
Principal-protected notes (PPNs) offer potential returns based on the performance of an underlying investment and a guarantee that, upon maturity, the investor will receive no less than the amount put in.
Along with a defined return, RSPs can also have built-in hedging strategies, reducing your risk as an investor, and may offer guaranteed protection of your initial investment.
As an investor, you need to be fully understand how the RSP works, be clear on how the return is calculated, and know what sorts of penalties may be incurred if you pull out early. Also, many RSPs do not have offer a full prospectus; instead, they are created with a less-detailed offering memorandum that does not need to be cleared with regulators.