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The Sizzle or the Steak: Exotic Market-Linked CDs

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With investors scouring the metaphorical earth and turning over its rocks for “safe” investments that provide yields in excess of inflation, it comes as no surprise that Investment Banks have started selling record numbers of exotic market linked Certificates of Deposit (CDs), a market where annual sales may total $25 billion per year.1 Rather than paying a fixed amount of interest, these CDs pay a variable amount of interest tied to the returns from anything from a stock index, or currency, to gold.  According to a recent Financial Advisor Magazine article, the Financial Industry Regulatory Authority (FINRA) has started looking into whether the buyers of these products understand their risks and lack of liquidity. After all, the last time investment banks starting packaging products of which nobody understood the risks, nobody got hurt, right?

FDIC insured market linked CDs may not be the toxic paper that collateralized debt obligations, pre-packaged tranches of subprime mortgages, and credit default swaps have been.  We are becoming increasingly convinced that somewhere on Wall Street a banner exists with the words, “It is better to ask for forgiveness than permission.”

All of the problems outlined above are only the symptoms of the underlying issue- that investors think they can get something for nothing (returns without risk).  These exotic products can often be replicated with combinations of bonds and options. Investors are not receiving a free lunch but in fact are paying a hefty sum to the salesman as evidenced by the brokerage commissions of 6% or more.1

For most investors, it can be assumed that the more exotic of a product they purchase, the less likely they are to do well. From one of our favorite authors, William Bernstein, "Understand that in investing, there is an inverse correlation between the sizzle and the steak - the most exciting assets tend to have the lowest long-term returns, and the dullest ones tend to have the highest....”.2

If you’ve been fortunate enough to have a healthy amount of disposable income and have elected to spend on an exotic product (luxury car, house, club memberships & etc), you derive more utility from it, even if the cost is higher. A highly recognized status symbol such as a Mercedes is more than a means of getting you from point-A to point-B (consider the dual zone climate control, heated leather seats, and safety for your family).

When it comes to investing, I have yet to see somebody valet park his market linked CD at the local country club and drop the jaws of his peers or protect his family in a head-on collision.  An investment’s sole purpose should be to maximize the investor’s wealth for any given amount of risk. Do yourself a favor. If you want a CD, buy a CD. If you want some stock market exposure at the same time, buy a small portion of a stock index mutual fund. Buying a hybrid product of the two is equivalent to paying a lot of money for the sizzle when it’s pretty easy to have the steak.

1http://www.fa-mag.com/fa-news/10014-market-linked-cds-under-scrutiny-while-luring-yield-starved-investors.html

2William J. Bernstein, The Four Pillars of Investing, (The McGraw-Hill Companies, 2010), pg. 183.