Swedroe: The Fairy Tale Behind 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”

One of the most well-known and most beloved forms of literature is the fairy tale. Although not every fairy tale is actually about fairies, they do tend to be fictitious and highly fanciful tales of fabled deeds and creatures. They are frequently derived from oral folklore based on myths and legends. And fairy tales are usually intended for children.

One of the most popular fairy tales is the Grimm Brothers’ Snow White. In the story, to eliminate her competition for “fairest in the land,” the evil Queen Maleficent disguises herself as an old woman and offers Snow White a beautiful, shiny red apple. Despite a stern warning from the Seven Dwarfs, Snow White cannot resist the temptation of the apple. She takes the bite that sends her into a deep sleep.

Adult Fairy Tales

Wall Street’s product machine is continuously pumping out fairy tales. Indeed, its product innovations can also often be called “fanciful tales of fabled deeds.” The only difference is that they are designed for adults. Like the poisoned apple, they have shiny features designed to entice naive investors.

Despite the wide variety of “fanciful tales” available, nearly all of them have one thing in common: Although they look appealing to investors, they have attributes that make them much more attractive in reality to the seller than to the buyer. Typically, these products fall into the category of what are referred to as “structured products.”

Structured products are packages of synthetic investment instruments specifically designed to appeal to certain needs that investors perceive aren’t being met by other available securities. They are often packaged as asset allocation tools that can be used to reduce portfolio risk.

Structured products usually consist of a note and a derivative, meaning the product derives its economic value by reference to the price of another asset, typically a bond, equity, currency or commodity. That derivative is often an option (a put or a call). The structured note pays the interest at a set rate and schedule, and the derivative establishes payment at maturity.

Because of the derivative component, structured products are often marketed to investors as debt securities. Depending on the variety of structured product, full protection of the principal invested is sometimes offered. In other cases, only limited protection may be offered, or even no protection at all.

Over the past decade, structured investment products, also known as equity- or index-linked notes, have become increasingly common in the portfolios of retail investors. The 2016 Greenwich Associates survey of structured products reported nearly $60 billion worth are now being sold each year, and that suppliers are forecasting strong growth in the future. Among the biggest suppliers of structured products are HSBC, J.P. Morgan, Barclays, Goldman Sachs, Credit Suisse and BNP Paribas.

And this is not just a U.S. phenomenon. In some countries (such as Switzerland and Germany), approximately 6% of all financial assets are now held in structured products. Unfortunately, they remain “popular” for the same reasons many financial products are popular: either they carry large commissions for the sellers, or they so greatly favor the issuers that they are pushed on unsophisticated investors who cannot fathom the complexity (but are assured by the salespeople and advertising collateral that these are good and often safe products).

A Question Of Exploitation
Fortunately, there’s a substantial amount of research on structured products. We know, for instance, that sophisticated issuers create them because they lower their costs of capital and generate profits. Thus, whenever an individual investor buys a complex instrument from Wall Street, you can be sure they are being exploited.

The reason is simple: If the issuer could raise capital more cheaply with a straightforward, simple debt instrument, they would do so. Thus, the question isn’t whether or not an investor is being taken advantage of. The only question is: How badly is the investor being exploited?

Stefan Hunt, Neil Stewart and Redis Zaliauskas contribute to the literature on structured products through their March 2015 paper, “Two Plus Two Makes Five? Survey Evidence That Investors Overvalue Structured Deposits.”

The paper was written for the U.K.’s Financial Conduct Authority (FCA), which is “committed to encouraging debate among academics, practitioners and policymakers in all aspects of financial regulation.” Hunt and Zaliauskas are in the chief economist’s department of the FCA, and Stewart is a professor at the University of Warwick’s department of psychology.

The authors begin by noting: “Innovation in retail financial markets has led to increasing product complexity over the past two decades, but there is little evidence of a comparable increase in consumers’ financial capability. Over the same period, there have been numerous instances of mis-selling that have led to regulatory action in the UK. When examining whether the market for a particular complex financial product is working well, one of the things regulators need to ask is whether consumers can understand and adequately assess the products they consider buying.”

Later, Hunt, Stewart and Zaliauskas write: “The FCA has repeatedly fined structured product providers and voiced concerns about market practices, indicating that the market is not working well for investors. The fines imposed on a major provider of retail structured products, in 2011 and 2014, were related to failings in sales of structured capital at risk products and to misleading promotions of structured deposits.”

In other words, the purpose of their paper was to investigate how well consumers understand and value structured deposits, whether there are systematic biases in investors’ evaluation of the expected performance of the structured deposits, and whether providing targeted information improves this evaluation.

A Study Based On A Survey

Hunt, Stewart and Zaliauskas conducted a survey of 384 retail investors who had relatively well-diversified portfolios and who had previously bought or would consider buying structured deposits or other structured products. The authors showed the investors hypothetical examples of five popular types of structured products with returns linked to the performance of the FTSE 100 stock index.

To distinguish between expected returns driven by overall optimism about the market and difficulty in understanding how structured deposit returns derive from an underlying index, they asked investors about their views on the performance of the FTSE 100 index over the next five years.

The authors then compared investors’ expectations about FTSE 100 returns with the returns they expected from different structured products. This allowed them to calculate bias in how investors evaluate the structured deposits relative to the index. They next asked investors to rank the structured deposits against a range of fixed-rate deposits, taking into account the risk of the different structured deposits. Finally, they looked at whether various types of disclosures altered respondents’ valuations. Following is a summary of their findings:

• While investors’ expectations of the FTSE 100’s growth were, on average, well-aligned with the assumptions used in the author’s quantitative model, investors significantly overestimated the expected returns of all structured deposits, even the most simple.
• Investors overestimated expected product returns by 1.9 percentage points per year on average, adding up to 9.7 percentage points over the five-year term.
• Investors’ expectations were also significantly higher than the returns from the authors’ quantitative model.
• Returns were overestimated for all five products. The overestimation ranged from 1% to 2.5%, figures that are statistically significant. Only 1.6% of respondents did not overestimate any of the products’ returns, while 70% of respondents overestimated all of the products’ returns, leading to the products’ returns being overestimated in 86% of cases.
• Although all five structured deposits in the survey would have been unlikely to return more than simple fixed-term cash deposits, investors didn’t recognize this. In other words, they didn’t require a premium for the incremental risks of the products. Investors were valuing structured products as if they were risk-free.
• Once again demonstrating that overconfidence is an all-too-human trait, those thinking of themselves as above-average financial experts were 0.44 percentage points less accurate in translating their FTSE 100 expectations into product returns.
• The disclosure of likely product returns and risk had some effect on investors’ ability to adjust for initial incorrect valuations. Investors who had initially overestimated returns or underestimated the risk of returns were more likely to adjust their valuations following further information.
• “Scenario” disclosures (giving investors information about what would happen under hypothetical scenarios) had little effect on product revaluation, while quantitative model returns (telling investors the likely product returns based on the authors’ quantitative model) induced, on average, a 0.41 percentage point larger devaluation of structured deposits.

The authors also noted that “an FCA analysis of a large sample of UK retail structured products, including but not limited to those based on the FTSE index, suggested that products issued since 2008 and that had a maturity of three to five years on average underperformed National Savings & Investments five-year deposit rates.”

Hunt, Stewart and Zaliauskas concluded that behavioral biases, combined with features of structured deposits that can exploit these biases, lead investors to possess unrealistically high expectations of the products’ returns and impede their ability to evaluate and compare structured products to each other and against other deposit-based alternatives.

What’s more, these products’ design and distribution strategies (often using commission-driven salesforces) exploit consumer weaknesses, likely leading consumers to make mistakes in comparing the options and, thus, buy overpriced products. Sadly, they also concluded: “Our findings suggest that there are limits to how much can be solved just by providing information.”

The authors’ findings are entirely consistent with prior research on structured notes, which we will explore in more detail later this week.

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