Aside from selling traditional stocks and bonds, Wall Street’s investment banks sell structured products to provide different return characteristics. These products are structured like notes with specific return terms and maturity dates. Unlike bonds with fixed coupons, the return during the period of investment is linked to an underlying asset. Depending on how these products are constructed, they can provide an infinite number of investment returns.
Many structured products limit the upside return of a risky asset, such as a stock index, in exchange for protection against losses in that asset. These types of products appeal to risk averse investors. Investment banks usually combine a zero-coupon bond with a derivative. The following is an example of a product that was recently marketed:
These characteristics look appealing at first blush. A retail investor may think, “I’m not greedy, I’ll cap my earnings at about 20% so that my investments lose 10% less than the market loses in a bear market.” However, if tested according to recent market results, the structured returns would not be attractive relative to market returns.
For example, a 2-year total return of 20.5% is slightly below the annualized total return of the DJIA over the last 25 plus years (9.8% vs 9.9%). In other words, you’re capping your return at slightly below the average. Additionally, this product is based on the price movement of the index only, which is necessary given the way the product is constructed using derivatives, while an alternative equity investment would include dividends returns. The downside protection is nice, but over the last 25 years the DJIA return was negative during a two year stretch less than 20% of the time, meaning the downside insurance would not often be a factor.
So how would an investor have done using a product like this over the last 25 or so years? The average return would have been 13% over a 2-year cycle. The average is weighed down by the asymmetrical payout due to the capped total return but nearly unlimited downside (up to 90%). So bad market cycles, e.g. during the Great Financial Crisis, when the market is losing more than 20% and the products provides partial protection, are not fully offset by strong years, i.e. those following the crisis.
If an investor had returns like the total return of the DJIA, the average 2-year cycle return would have been 21%. This is driven by the strong bull markets providing 2-year returns greater than 20.5%. While the downside protection comes into play less than 20% of the time, the DJIA total return outperformed the cap almost 60% of the time. The characteristics appear appealing on the surface, but history suggests the product is not a good investment.
Wall Street makes significant commissions on these products. These costs are not explicit but built into the spread between the true costs of what’s sold and the cost that retail investor pays for the protection. As in many areas of investment, Wall Street is exploiting a behavioral bias (here it’s the fact that the pain of losing is perceived as more dire than the pleasure from gains) to profit.
There are other downsides to these structured products, including:
Counter-party Risk: Structured products are created as notes underwritten by an investment bank. If the backer of the note is bankrupt or unable to meet its obligations, then the investor will not be paid regardless of how the security performed absent the risk. These securities are also unsecured since there is nothing backing the value of the note. Given this risk, the creditworthiness of the issuer needs to be considered carefully. As became apparent during the Great Financial Crisis, many banks are operated with less creditworthiness than expected by the public.
Illiquidity: Unlike a stock, structured products are illiquid meaning that they cannot be easily sold in a functioning market. In the above example, the issuer only allows 10% of the security to be sold every year for the length of the contract. Typically, investors demand higher returns from illiquid investments than comparable liquid investments since one’s money is tied up for longer time periods.
Costs: Investment Banks market structured products as free. However, there are explicit costs associated with buying the underlying securities that comprise the product. Purchasing these securities incurs institutional costs estimated at 0.5-1.5%. However, retail costs are often much higher since brokers selling these products will also include their own spreads or markups. Estimates are that these expenses can total 3-5%.
We believe that every investment should be reviewed through a risk reward analysis. For structured products, the potential rewards are overshadowed by the risks detailed above.