Everyone likes the potential returns of stock. I mean who wouldn’t like the chance to gain 10% per year or more. The downside, on the other hand, could mean large losses. If there was only a way to gain the upside potential of stocks without having the risk that they can lose value – enter Structured Products. They are marketed under many different names, but underlying idea is basically the same.
How do they work?
Structured Products come in many shapes and sizes, but here’s a typical example.
“Bank ABC has a new and exciting product it is only offering to its best clients. You give us a lump sum of money for five years. At the end of five years we will, at a minimum, return 100% of the principal. However, your investment will be linked to the S&P 500. If the S&P 500 goes up 20% over the five years you receive 20%. If the S&P 500 goes down 20% over the five years you will still receive 100% of your principal.”
You can see why people can be drawn to these types of investments. What’s not to like? You gain the upside of stocks without the risk of losing money. However, this is not the whole story. As is with most cases in the world of financial products: when it seems too good to be true, it probably is.
What’s The Problem?
First let’s look at this from the banks prospective. The CFO’s job is to raise capital at the lowest cost possible. If he/she thought they could raise capital cheaper by simply doing a five-year bond issuance, they would. This fact alone should give you pause.
What you are actually buying from the bank is an unsecured bond. Because of this you are taking credit risk for which you should be compensated. Since it is unsecured credit you are even further down on the list of people to get paid if the bank were forced to liquidate its assets and pay their creditors. Currently the yield on five-year US treasuries is about 1.7%. You should get a premium above that for taking this credit risk. A quick look at bank debt tells us that you should get a premium of about 2.5% for taking this credit risk for five years.
The next problem is with the S&P 500 index. It is a price-only index, which means that it does not include the dividends that the companies in the index are paying. Currently the dividend yield on the S&P 500 is about 2%.
There is also a liquidity problem. These instruments are very illiquid – if you have to sell them to raise cash or to rebalance your portfolio it can be very expensive or, in some cases, may not be possible to sell. The amount of liquidity in one’s portfolio should not be overlooked and is different for everyone, but for the sake of argument let’s assume we don’t require any additional return (a “liquidity premium” of 0%) as a result of making this illiquid investment.
So far without even considering the cost of illiquidity we are up to a cost of 4.5%. We will assume there are not hidden fees in the fine print – an assumption you should NOT make if you were evaluating them.
The last piece of the puzzle is to determine the cost of the put option. The put option is essentially your downside protection. Luckily we don’t need to do any research to know what the cost is. Unless the bank’s CFO is feeling very charitable, we KNOW that the cost of the derivative instruments they will buy to provide the downside protection is less than 4.5%. If this weren’t the case, the bank would be losing money!
These structured products are meant to be sold, not bought. They are designed to lower the cost of capital for the issuing institution which translates to lower expected returns for you, although it is not obvious at first glance. The marketing departments prey on the emotions we humans have about wanting to grow our investment without taking any risk. Here is an email I got just today from a major bank trying to get me to sell these types of products to my clients.
Dear Mr. Robbins,
Can we arrange a quick discussion on some new products from **** Bank: Buffered Market-Linked Notes? It includes:
- Short-, medium-, or long- term offerings
- Buffered downside protection of 10% to 100%
- Uncapped upside participation of 105% to 140%
- Can be linked to any major index or sector
- Fee-based product
**** Bank Specialist
There may be a structured product out there that is a good deal, but I have yet to see one. If you are ever tempted to buy one of these products make sure you do the math to see who is actually getting the good deal.