The dubious appeal of structured products

Structured investment products are frequently advertised in the newspapers.

I have serious misgivings about investing in structured products (SPs), and am glad not to have done so, going by the experiences of those I know who have dabbled in such products.

SPs are riddled with problems and pitfalls for the retail investor, and it's difficult to see how they are better than a plain vanilla mutual fund, or even direct investment into stocks and bonds.

The biggest problem with SPs is probably transparency. The transparency of product structure is poor. In addition, most retail investors are unsophisticated; they simply do not understand what the product is and how it makes or loses money.

SPs are really just derivatives, but with a jazzed up name that sounds better and not as risky. Derivatives do not in general exhibit linear behavior relative to their underlying assets. They are highly complex instruments whose workings are usually not immediately obvious to even finance professionals.

[For further (casual) reading on traders and derivatives, read Satyajit Das' Traders, guns and money.]

How SPs are structured and how they perform is highly opaque. While mutual funds are also somewhat opaque (usually only the top 10 holdings are disclosed, and even then, that's at the reporting date), SPs have a level of opaqueness that is impenetrable even for financial professionals.

Why do I say that even financial professionals would find these SPs impenetrable? Because in recent weeks, I have seen advertisements for SPs that are constructed out of synthetic CDOs and other exotic credit derivatives. Now of course you won't see this in the main tagline of the advertisement. More likely than not, it'll be buried in the fine print.

With the credit crisis still going strong, it's natural to ask how so many finance professionals and big banks failed to see the crisis coming, and how they got it so wrong, since in many cases, the provenance of these credit derivatives starts directly from their own securitization activities.

If even credit agencies can get their models of how credit derivatives perform wrong(or if they deliberately obfuscate), ordinary retail investors haven't got a prayer in understanding these things.

[As an aside, run far away from any SP that is composed of credit derivatives! The big banks aren't done with their writedowns by any chance and would only love to offload them to some unsuspecting patsy.]

Leaving aside SPs that are related to credit derivatives, I have a strong suspicion that SPs in general are structured to work better for the issuer than for the investor. For example, "early redemption", a feature trumpeted by many SPs, can just as easily mean "buying you out of your potential upside". What it really means is that the issuing house has an embedded call option on your investment and can redeem it when conditions are most favorable for the issuing house to do so (and frequently least favorable for the retail investor).

There is also the question of fees. The fee structure for SPs is again usually not transparent, but if there is any rule in fee-paying in finance, it's probably that fancier ice cream with toppings is always more expensive. That is, if hedge funds can charge more presumably because they have more complex strategies, then structured products, going by the same rule, are probably expensive from a fee standpoint. Warren Buffett is notably against investments that have high fees.

Two other sneaky tricks that managers of SPs use:

1. Capital guarantees, but only if the investment is held until maturity, in which case you would still lose out as the real value of your investment would have been eroded by inflation in the intervening period. And if you liquidate your investment before maturity, you might suffer a loss still.
2. Return of capital dressed up as dividend payouts. This is notorious among SPs that advertise their regular payout feature. The fine print states that any payout may erode the capital of the fund, which essentially means you are loaning them the money for free, minus the fund management fees.

However, after all that's said, that’s not to say that SPs, and more broadly, derivatives, do not have their place in a portfolio. As long as you have a view on how the markets will move, a derivative may be useful for gaining exposure in accordance with that view. That’s why options, discount certificates, futures, exchange traded funds and other derivatives may still be useful in an investment portfolio.

The lack of transparency with SPs does not allow the investor to make an informed investment decision though. That small glossy one-page rectangular brochure printed on both sides is NOT sufficient information on which to base a decision. And given the poor product knowledge of most bank shills, you’re not likely to get the full accurate picture of the product when it’s being hard sold to you. Your only hope is to read and understand the prospectus, but not everyone has the skills to to do that.