Swedroe: The Problem With Structured Notes

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. In 2013 alone, more than $40 billion in structured notes were issued.

And this is not just a U.S. phenomenon. A 2009 study by Marc Rieger and Thorsten Hens found that in some countries (Germany and Switzerland, for example) approximately 6 percent of all financial assets are held in structured products.

High Fees, Boggling Complexity

Structured products are financial derivatives where the payoff at maturity depends on one or more traditional assets (mostly stocks or stock indexes). Unfortunately, they are “popular” for the same reasons that many other financial products become trendy and fashionable. Structured products either tend to carry large commissions for the people who sell them, or they so greatly favor the issuers that they are pushed onto unsophisticated investors who cannot fathom their complexity.

Of course, clients and prospects are assured by salespeople and advertising materials that these are good and often safe products.

A Great Deal For Issuers

There’s a substantial amount of research on structured products. We know, for instance, that issuers create them because they lower the cost of capital and generate profits. So, whenever an individual investor buys a complex instrument from Wall Street, you can be pretty sure that the investor is being exploited. Why?

The reason is simple in its logic. If the structured product issuers could raise capital more cheaply with a straightforward and simple debt instrument, they would do so. Thus, the question isn’t whether an investor is or is not being taken advantage of; that investors are being exploited is practically a given. The real question is one of how badly.

Fortunately, there’s academic research to answer that question, and it isn’t pretty.

Troubling Research

The 2011 study by Marc Rieger and Thorsten Hens cited previously—“Why Do Investors Buy Structured Products?”—concluded that, for rational investors, any utility gains from structured products are typically much smaller than the products’ fees.

If you’re wondering just how much smaller those 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 appeared in the May 2011 issue of the Journal of Financial Economics—found that the offering prices for 64 issues of a popular retail structured equity product were, on average, almost 8 percent greater than estimates of the products’ fair market value. Those comparisons were obtained through the use of option pricing methods.

As you might guess, especially given the 8 percent shortfall, the authors discovered that the mean expected return estimate on the structured products they analyzed came in at slightly below zero. They concluded that the issuing firms either shrouded some aspects of their more innovative securities or introduced complexity to exploit uninformed investors.

One Unsettling Example

The authors of one particular 2011 study examined the evidence on another popular type of structured product, called the principal-protected absolute return barrier note (ARBN). ARBNs guarantee to return the face value of the note at maturity and pay interest—that is if  the underlying security’s price doesn’t vary excessively.

The principal protection feature guarantees full payback of the note’s face value at 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 large-cap S&P 500 Index and the Russell 2000 Index of small-cap stocks.

Overpaying, And For What?

Not surprisingly, the paper concluded that the fair price of the ARBNs they studied was about 4.5 percent below the actual issue price. In other words, investors were paying $1 for something worth just 95.5 cents. Given that, generally speaking, ARBNs are short-term investments (maturities typically ranging from six months to three years, but most ARBNs have maturities between 12 and 18 months), 4.5 percent 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.

A Lehman Brothers Tie-In

The authors also cited a similar study that found structured products from the now-defunct financial services firm Lehman Bros. generally had implied yields below the one-year Libor rate.

This indicates that Lehman used structured products to finance its operations at submarket rates, especially when the company’s credit quality decreased sharply in 2007 and 2008.

More Overpricing

As further evidence, Carole Bernard, Phelim Boyle and William Gornall—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 percent.

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

Finally, the summer 2015 edition of The Journal of Investing contains a new study, “Ex Post Structured-Product Returns: Index Methodology and Analysis,” further contributing to the literature on structured notes.

A Study In Underperformance

The authors—Geng Deng, Tim Dulaney, Tim Husson, Craig McCann and Mike Yan of the Securities and Litigation Consulting Group—analyzed ex-post returns data from 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, JPMorgan Chase, Lehman Bros., Morgan Stanley, RBC and UBS). The products were issued from 2007 through 2014.

They 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 mean returns, standard deviation and Sharpe ratios for the five structured product indexes as well as the comparable figures for the S&P 500 Index and the Barclay’s Aggregate Bond Index. 

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

More Like Stocks Than Bonds

The results clearly show that structured products have dramatically underperformed alternative allocations to stocks and bonds, largely because the products were overvalued. The authors also demonstrated that excess returns to the structured product indexes exhibit a stronger linear relationship with the S&P 500 than to the bond index. Yet structured products are often sold as alternatives to bonds.

Not So Special After All

The results also indicate that structured products are not a unique asset class. The authors concluded their “ex-post analysis of structured product returns shows that a simple portfolio of stocks and bonds are better investments than structured products.” They add: “Results of our index analysis should cause investors and their advisers to avoid structured products.”

Regulations Required

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

While the FDA can often take years to approve a new product or device, the review of financial innovations should be much cheaper and faster because it should entail the use of readily available public data and involve 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 bad medicine can be to your physical health. Some individuals need to be protected from exploitive financial firms seeking not to help them but to plunder their savings and treat them like muppets.

Sellers Should Be Fiduciaries

If the fiduciary standard of care were applied to the sale of financial products, it’s likely that virtually all structured notes would disappear. If a person selling the product cannot demonstrate that purchasing it is in the buyer’s best interest, why should that sale be allowed? I can’t think of a single reason.

This standard should be used for all financial products, but especially for the whole category of structured products (such as equity-linked CDs and equity-indexed annuities) created by sophisticated financial institutions for sale to naive investors.

The complexity of structured products allows the firms creating them to embed fees that frequently range from exploitative at best to amoral at worst. Just as broker-dealers can be fined for excessive markups on bonds, at the very least, marketers of structured products should be held to the same standard after what constitutes a “reasonable” fee is established.

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

This simple recommendation would go much further to protect individual investors and society than a lot of legislation and regulation currently on the books.

Summary

Given the evidence detailed here, 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 gains—gambling to avoid sure losses, overpaying for the small possibility of a large gain, mis-estimating probabilities, overconfidence and the power of the marketing machines on Wall Street.

From the issuers' perspective, the products are great because their complexity allows them to exploit investors’ behavioral biases and raise capital at well-below-market rates. In fact, the complexity increases the likelihood that investors will mis-estimate 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.” Sounds like good advice regarding structured products as well. 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.