Swedroe: Avoid Structured Products Game

Investors are overly optimistic about their odds when it comes to structured products.

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.

Further Evidence

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.

ARBNs’ Premium

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.

The study also found that the yields on ARBNs were lower than corresponding corporate yields. Many were even lower than the risk-free rate! The authors cited a similar study that found structured products from the now-defunct Lehman Bros. generally had an implied yield under the one-year Libor rate. This indicates Lehman used structured products to finance its operations at submarket rates, even when the company’s credit quality had decreased sharply in 2007 and 2008.

As further evidence, Carole Bernard, Phelim Boyle and William Gornall, the authors of the study “Locally Capped Investment Products and the Retail Investor,” which was published in the Summer 2011 issue of The Journal of Derivatives, found that the contracts were, on average, overpriced relative to their fair values by about 6.5%.

And my book, “The Only Guide to Alternative Investments You’ll Ever Need,” which I co-authored with my colleague, Jared Kizer, contains a chapter on structured notes that includes an analysis of two products, showing how expensive they were, as well as how investors could easily find more efficient alternatives.

Structured Products Vs. Stocks & Bonds

The Summer 2015 edition of The Journal of Investing contains a study, “Ex Post Structured-Product Returns: Index Methodology and Analysis,” that contributes to the literature addressing structured notes. The authors, Geng Deng, Tim Dulaney, Tim Husson, Craig McCann and Mike Yan of the Securities and Litigation Consulting Group, analyzed the ex-post returns of more than 20,000 individual structured products issued by 13 firms (Bank of America, Bank of Montreal, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, J.P. Morgan, Lehman Bros., Morgan Stanley, RBC and UBS) from 2007 through 2014.

The authors then built a structured product index and subindexes for reverse convertibles, single-observation reverse convertibles, tracking securities and autocallable securities by valuing each structured product in their database each day. The following table shows the mean returns, standard deviation and the Sharpe ratios for the five structured product indexes, as well as the comparable figures for the S&P 500 Index and Barclays Aggregate Bond Index.

To isolate the performance results from problems associated with overpricing on the date of issuance, the authors also calculated the initial “shortfall” in pricing:

The results clearly show that structured products have dramatically underperformed alternative allocations to stocks and bonds due to overvaluation of the products. The authors also showed the excess return of the structured product indexes exhibited a stronger linear relationship with the S&P 500 Index than to the bond index. Yet they are often sold as alternatives to bonds. These results indicate that structured products are not a unique asset class.

The authors concluded: “Ex-post analysis of structured product returns shows that a simple portfolio of stocks and bonds are better investments than structured products.” They added: “Results of our index analysis should cause investors and their advisers to avoid structured products.”

Regulations Required

In the University of Chicago working paper, “An FDA for Financial Innovation: Applying the Insurable Interest Doctrine to 21st Century Financial Markets,” Eric Posner and E. Glen Weyl propose that, when firms invent new financial products, they be forbidden to sell them until they receive approval from a new government agency, The Financial Products Agency, which would be designed along the lines of the FDA (the regulators responsible for screening pharmaceutical innovations).

While the FDA can often take years to approve a product, the review of financial innovations should be much cheaper and faster, because the process should involve readily available public data and well-known mathematical calculations.

We’ve already seen that investments in derivatives and other innovations can be just as dangerous to your financial health as taking a bad medicine can be to your physical health. Naive individuals need to be protected from exploitive financial firms seeking not to help investors, but to plunder them, treating them as Muppets. If the fiduciary standard of care were applied to the selling of financial products, it’s likely that virtually all structured notes would disappear.

If people selling the product cannot demonstrate they believe that its purchase is in the buyer’s best interest, why should that sale be allowed? I can’t think of a single reason. I believe this standard should be applied to all products, but especially to the entire category of structured products; for example, equity-linked CDs and equity-indexed annuities, created by sophisticated financial institutions to sell to naive investors. Their complexity allows their creators to embed fees that are, at best, exploitative and, at worst, amoral.

Just as broker-dealers can be fined for using excessive markups on bonds, those selling structured products should likewise be held accountable, with a standard for what is a reasonable fee to be established.

Unfortunately, just as is the case with pharmaceuticals, full disclosures are simply not enough, because the complexity of some financial products is such that there is often virtually no chance that the typical investor can determine the nature of the fees or perhaps even the risks involved. How many investors will even read a 70-page disclosure document?

I would argue that this simple recommendation would go much further to protect individual investors and society as a whole than the 2,319-page Dodd-Frank Act.

Summary

The demand for structured products can only be explained by well-known behavioral factors, such as loss aversion (studies suggest that losses are twice as powerful, psychologically, as an equal-sized gain), gambling to avoid sure losses, overpaying for the small possibility of a large gain, misestimating probabilities, overconfidence and the power of the Wall Street marketing machine.

From the issuers’ perspective, structured products are great because their complexity allows them to exploit the behavioral biases of investors and raise capital at well below market rates—their complexity only increases the likelihood of investors misestimating probabilities. From the buyer’s perspective, they’re a disaster.

The perfect conclusion to this analysis comes from the film “War Games.” Joshua (the supercomputer) states: “A strange game. The only winning move is not to play. How about a nice game of chess?”

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.