As a general rule of thumb, the more complexity that exists in a Wall Street creation, the faster and farther investors should run.
—David Swensen, “Unconventional Success”
Earlier this week, I unpacked a recent study from the U.K. that concluded investors’ behavioral biases, combined with features of structured products that can exploit these biases, lead them to have unrealistically high expectations of structured products’ returns, and impede their ability to evaluate and compare certain structured products to each other and against other alternatives.
In addition, structured products’ design and distribution strategies (often using commission-driven salesforces) exploit consumer weaknesses, leading investors to commit errors when comparing their options and, thus, to buy overpriced products. Today I’ll explore previous research on structured notes, all of which supports the same conclusion.
The 2009 study “Why Do Investors Buy Structured Products?” by Thorsten Hens and Marc Oliver Rieger concluded that any utility gains investors derive from structured products are typically much smaller than their fees.
If you’re wondering just how much smaller the benefits are, Brian Henderson and Neil Pearson, authors of the study “The Dark Side of Financial Innovation: A Case Study of the Pricing of a Retail Financial Product,” which was published in the May 2011 issue of the Journal of Financial Economics, found that the offering prices of 64 issues of a popular retail structured equity product were, on average, almost 8% greater than estimates of the products’ fair market values obtained using option pricing methods.
As you might guess, given the 8% shortfall, Henderson and Pearson found that the mean expected return estimate on the structured products was slightly below zero. The authors concluded that the issuing firms either shroud some aspects of their innovative securities or introduce complexity to exploit uninformed investors.
Geng Deng, Ilan Guedj, Craig McCann and Joshua Mallett, authors of the study “The Anatomy of Principal Protected Absolute Return Notes,” which appeared in a 2011 issue of The Journal of Derivatives, examined the evidence on a popular principal-protected product known as absolute-return barrier notes (ARBNs). ARBNs are structured products that guarantee to return the face value of the note at maturity, and pay interest if the underlying security’s price does not vary excessively.
The principal protection feature guarantees full payback of the note’s face value at time of maturity, as long as the investor holds the note to maturity and the issuer does not default on the note. The study covered 214 ARBNs issued by six different investment banks. Most of the products were linked to indexes such as the S&P 500 Index and the Russell 2000 Index.
Not surprisingly, their conclusion was that the ARBNs’ fair price was approximately 4.5% below the actual issue price. Investors were paying $1 for something that was worth just 95.5 cents. Given that, generally speaking, ARBNs are short-term investments with maturities typically ranging from six months to three years (and with most having maturities between 12 and 18 months), 4.5% is a hefty premium to pay.