Structured Products – Stay Away!
What are structured products?
As I write this memo, the major investment banks and the legions of stockbrokers they employ are pushing structured products out onto their customer base like never before. A structured product is an investment created by Wall Street investment banks that combines traditional investments like stocks and bonds with derivates such as puts and calls. Structured products are created for and marketed to a very wide range of investors. For example, some structured products are geared towards investors who desire principal protection while others are designed for investors who want to speculate and desire leverage to enhance their return opportunity. In all cases, structured products are just that – products. These products are created and sold to generate profits for the investment banks who manufacture them. Sometimes they perform and the customer makes money, sometimes they don’t and the customer loses money. Win, lose or draw, the stockbroker who sells them makes money and so does the firm who made them.
Why are they being sold now?
In the wake of the financial crisis, the major investment banks need to find new and creative ways to make profits. By simply packaging together a stock with some options attached, Wall Street banks have found a way to generate handsome commissions with little overhead.
What are some of the risks that I should be aware of?
Counterparty risk: Despite that fact that your stockbroker may tell you a certain investment is guaranteed or principal protected, that protection is only as good as the firm providing the protection, i.e. the backstop for the note you are buying. For example, Lehman Brothers was the backstop to a large number of structured products which were sold as principal protected notes. These were fancy investments that provided the investor with the opportunity to participate in stock market rallies, but not lose anything if the market went down – hence the principal protection. However, when Lehman Brothers went bankrupt, the investors who owned those notes watched their investment lose over 90% of its value.
Liquidity risk: Once you purchase a structured product, you should be prepared to hold the investment all the way to maturity. These investments do not have a liquid market like the stock market, and if you try to sell before maturity you may sell at a significant discount, called the spread, just to get your money back. The stockbroker and the firm who sold you the product generally are under no obligation to buy the note back or make a market in the note. Typically if you try to sell before maturity your brokerage firm will try to find another firm or investor who is willing to purchase the security from you – the question becomes, at what price?
Leverage: This should be common sense, but if you are being offered two or three times the return of a stock or an index, there must be some significant risk and leverage underneath the hood of the investment. What goes up can also come down. Often times these targeted bets are no different than a casino at Vegas, so think twice before you roll the dice here.
What else should I be thinking about with respect to structured products?
Lack of transparency and large commissions. The financial advisors/stockbrokers who work at the big Wall Street banks adhere to something called the suitability doctrine. The suitability doctrine is a lower standard of care when compared to that of a fiduciary/investment advisor and requires only that the financial advisor first determine a customer’s risk profile before he or she sells the customer investments. So long as an investment is suitable, the financial advisor can sell the investment to the customer. As a result, the financial advisor is able to sell a customer the most expensive or highest commissioned products he or she can find as long as the investments are suitable. Structured products carry commissions and the commissions can be as great as 3% of the amount you invest. These non-transparent commissions can hamper the performance of the investment.
When you add it all up, there seem to be a number of roadblocks to investing in these complicated investments that seem to be all over Wall Street these days. If your stockbroker attempts to convince you to buy one of these products, be sure to read the fine print on the massive prospectus that he or she is required to send to you. You should be asking: What is the commission the stockbroker is receiving to sell me this product? What are the specific risks involved with the proposed product? Why is this product better than a traditional asset allocation plan? How does this product improve my diversification or return opportunities?
Ethan S. Braid, CFA
HighPass Asset Management