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).