An investment that robs you of 4.5 percent

(MoneyWatch) 

Wall Street firms often treat retail investors as patsies. Sophisticated Wall Street firms exploit both their knowledge advantage and the behavioral biases of individual investors. One way that they do so is by creating complex products called structured investments. A recent study showed that, on average, these investments aren't even worth what you paid for them.

Whenever you buy a complex instrument from Wall Street, you can be sure you are being exploited. The reason is that if the issuer could raise capital more cheaply with a straight-forward and simple debt instrument, it would do so. Thus, the question isn't whether you're being taken advantage of. The only question is, How much are you being exploited? A new study, "The Anatomy of Principal Protected Absolute Return Barrier Notes," by the Securities Litigation and Consulting Group, sought the answer to that question.

Investors lose $113 billion on complex investments
Principal protection likely isn't worth the costs
Why you should avoid structured settlement investments

The study examined the evidence on principal-protected absolute return barrier notes (ARBNs). ARBNs are structured products that guarantee to return the face value of the note at maturity, and pay interest if the underlying security's price doesn't vary excessively. The principal protection feature guarantees the full payback of the note's face value at maturity, as long as the investor holds the note to maturity and the issuer doesn't default on the note. The study covered 214 ARBNs issued by six different investment banks. Most of the products were linked to indexes such as the S&P 500 or the Russell 2000.

Not surprisingly, the study found that the ARBNs' fair price was about 4.5 percent below the actual issue price. In other words, investors were paying $100 for something that was worth just $95.50. Given that ARBNs are generally short-term investments, with maturities typically ranging from six months to three years, 4.5 percent is a hefty premium to pay.

The study also found that the yields on ARBNs were lower than corresponding corporate debt yields. Many were even lower than the risk-free rate! This shouldn't be surprising, as I noted in the opening paragraph.

The authors also cited a similar study that found that Lehman Brothers' structured products generally had implied yields below the one-year LIBOR rate. This indicates that Lehman used structured products to finance its operations at sub-market rates, especially when the company's credit quality decreased sharply in 2007 and 2008.

The authors also noted that their finding of a 4.5 percent premium was lower than the premium on European reverse convertible products (another form of a structured note), but similar to the premium on U.S. dollar-denominated reverse convertibles.

In the competition between sophisticated financial institutions and retail investors, it's not hard to figure out who the winner is going to be. The only way for you to win that game is to not play.

[smpatel100]

Larry,

Nice article as always.
Would you put ETN issued by big banks in the same category as the structured notes?

regards,

[LarryswedroeCBS]

No one should buy ETNs because effectively you are lending money to a financial institution without being compensated for the credit risk. That is a hidden cost if you will.
Also they are generally illiquid and thus you should also receive compensation for an illiquidity premium, but don't.
Companies love them because they lower their funding costs because investors don't understand the risks.
Hope that helps
Best wishes
Larry

[LarryswedroeCBS]

CBSName
I agree completely, but unfortunately many investors don't understand they are taking that risk, or underestimate, as did many investors in Lehman notes.
Best wishes
Larry

[CBSName]

What kind of a guarantee applies only if the issuer doesn't default? Isn't that saying essentially, "you'll get your money back unless you don't"?