Shark Baiting

The Sharks Are Biting: Wall Street's Structured Products

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Shark Baiting

“Wall Street is a place where anything that can be sold will be sold”  – Warren Buffett

“You are just a buyer of Wall Street’s dreck” – Robert Soros

“They [structured products] are horrible investments for retail investors…Simple portfolios of bonds, stocks or the S&P 500 will beat structured products 99.5 percent of the time because of the heavy profit built into the pricing”  -Craig McCann, former SEC economist and founder of Securities Litigation & Consulting Group

Credit to Eduardo A. Repetto and Inmoo Lee of Dimensional

Over the years, IFA has had the chance to view the portfolios of many different prospects and clients (before they actually became clients). We have seen the underbelly of Wall Street at its very worst, complete with penny stocks, C-Class shares of hyperactive mutual funds, triple inverse Russell 2000 ETFs…well you get the idea. Lately however, there has been one type of product that has been showing up more often than we are comfortable with, structured products. Granted, the name sounds as innocuous as it is vague. To briefly explain, the structured products marketed to retail investors promise either the straight return or a multiple of the return of an index (usually the S&P 500) up to a certain level (say 15%) with partial protection on the downside (e.g., for the first 10% of negative return you are fully protected, but for each percentage point drop beyond 10% you lose a percentage point). They are typically designed by the whiz kid quants of Wall Street, the same geniuses who gave us the synthetic collateralized debt obligations and other monstrosities that nearly took down the whole economy. At first glance, structured products may look very enticing; after all, they offer you some upside and a little protection on the downside. What could be so bad about that? Plenty.

Perhaps the very first principle of investing is that there is no such thing as return without risk. No free lunches. In a similar vein to the First Law of Thermodynamics, risk can never be obliterated; it can only be transferred from one party to another. If your broker is offering you a product that promises partial upside of the market with downside protection, you can be absolutely sure that the party that has agreed to take on the downside risk on your behalf is being paid to bear that risk, so the question you should naturally ask is, “Who is paying this party to take on my risk?” The answer, of course, lies in the mirror, but the costs are not transparent. The cost may show up at the end as a much lower return than what would have been received in a boring index fund.

One of the key points to understand about structured products is that they are constructed out of positions in options (both long and short), Treasuries, and sometimes positions in the underlying index itself. The issuer of the structured product, after collecting your payment, will buy these building blocks at a lower price and pocket the difference as immediate profit, after paying your broker his commission. These products are often designed to help the issuers unwind positions that they have due to trades with other institutions. This brings us to a very important point: Structured products carry default risk of the issuing company. Buyers of Lehman Principal Protected Notes have had to swallow this bitter pill. So even though structured products may appear to provide market-based returns, investors in these products are staking their nest egg on the fortunes of one company. Bad idea! An additional problem with structured products is liquidity. The hapless investor who needs to sell one before maturity should expect to have an experience similar to the shorn sheep pictured below.

Like all the other products that come out of the “too big to fail” companies of Wall Street, they are not designed in the best interest of investors, and that alone should be reason enough to steer clear. The complex payoff structures of these products are extremely unlikely to meet the needs of any investor, and they have no special magic that allows them to offer higher expected returns with lower risk. IFA has consistently counseled investors not to be buyers of Wall Street’s dreck. Rather than incurring the hidden costs and risks of structured products, they should favor transparent, risk-appropriate, low cost portfolios of index funds.