Marcie Knittel is Senior Vice President and Director of the Derivatives Strategies Group at National City, which works with private banking clients to assess and reduce investment risks. In the last issue of Insights, she discussed the risks of a concentrated equities position.

INSIGHTS:
Last time, we looked at a specific risk. But what about the overall risk in a volatile equities market?

MK:
There are a number of ways to reduce that risk. One new tool is structured notes, which are debt obligations whose return is tied to the performance of a measurable underlying asset class, index or security.

INSIGHTS:
How do they work?

MK:
Let’s take the example of a $10,000 structured note based on the S&P 500 with a four-year term offering 120 percent of the price appreciation of the index with a 20 percent downside buffer. If the S&P appreciates 30 percent over the term, the investor receives $13,600. If the index declines 19 percent—that is, within the buffer—the investor receives her entire initial investment of $10,000. Any loss beyond the buffer is reflected in the return on a dollar-for-dollar basis. Also, during the term, the notes are priced daily, so they can be sold prior to maturity at their current value.

INSIGHTS:
Why not always invest this way?

MK:
There are trade-offs associated with these notes. First, they do not offer interest or dividend income. If you held an index fund based on the S&P 500, your total return over the period in our example would include dividend payments. Also, because these notes have a fixed maturity date, your ability to respond to market conditions is limited. If the note is way up and then drops on the day before it matures, you can’t hold it as you might a stock or fund.

INSIGHTS:
What types of investors might find structured notes appealing?

MK:
Someone who is bullish on the equity market but who is particularly risk-averse might consider them. They offer a way to invest in more volatile market segments while reducing downside risk. And they can be very useful for asset allocation. When we structure these notes, we take our cue from the Asset Allocation Committee. For example, the committee recently decided that we should purchase commodities exposure for our clients, since they have a low correlation to stocks. But commodities are extremely volatile and beyond the reach of most accounts. By using a note based on a broad basket of commodities, we can take advantage of the benefits with reduced risk. But the notes are definitely not for accounts that depend on current income from their investments.

>> For More Information, e-mail Marcie.Knittel@NationalCity.com.