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News, research and market insights from our team of experts.
"Never let a good crisis go to waste" – Sir Winston Churchill
Financial innovation has provided immeasurable societal benefits regardless of what the mainstream media tells us. Financial innovation has greased the gears of capitalism by reducing structural inefficiencies, increasing borrowers’ access to willing lenders and enabling rational market participants to more efficiently manage risk.
Major financial institutions appear to have heeded Churchill’s advice by ramping up the marketing of equity-linked structured products following the Global Financial Crisis of 2008. Brilliantly devised structured notes promising principal protection and upside participation have proven to be a hit with emotionally-scarred retail investors. These investors place a high premium on principal protection, and brokerage firms are more than happy to engineer away the risk of capital loss. For their troubles brokerage firms receive yet another highly profitable, and opaque, revenue stream for their shareholders.
Principal Protected Notes
One of the most popular structured products marketed to retail investors is the principal protected note. Issuers promise buyers of these securities the guaranteed return of principal at maturity and any positive performance of the underlying index up to a capped level. The note appears as an unsecured liability on the issuing firm’s balance sheet, and the issuer hedges their obligation by bundling, or “structuring” a number of financial products to create the desired economic exposure. For the more financially inclined, the component products used to hedge a principal protected note are typically a zero-coupon treasury strip with a maturity corresponding to the structured note paired with a call spread of equity index options.
The principal protected note appears to be another shining example of financial engineering mitigating unwanted risks and improving portfolio efficiency. Upside exposure to the market, no principal at risk and no annual fees. What’s not to like?
While principal protected notes do appear to offer investors attractive structural enhancements, astute investors should ask themselves “at what cost?”. A number of relevant items to consider when evaluating structured notes include:
When stepping back and rationally evaluating structured wealth management products, are the protections provided worth the considerations and conflicts? Can you be certain that the issuer will even be able to make good on their “guarantee” in a truly draconian market environment? History and basic statistics suggest the answer to these questions is “no”.
So why then are structured notes so popular? We suspect investors are naturally drawn to the promises of principal protected notes due to behavioral biases such as loss aversion, recency bias and the tendency to assign irrationally high probabilities to unlikely events. Brokerage firms are acutely aware of these behavioral biases, and thus frame their marketing pitches to exploit our psychological deficiencies. By focusing on the attractive features structured notes provide, issuers are able to lure investors without ever divulging the exceptionally high implicit costs of those protections.
The Father of Modern Portfolio Theory, Harry Markowitz, is often quoted as saying that “diversification is the only free lunch in finance”. Objective fundamental and quantitative analysis allows us to conclude the Nobel Laureate’s words still ring true. We believe that pairing lowly-correlated niche strategies with reasonably priced passive exposures is still the most reliable way to mitigate risk and grow wealth over the long term.
While we are generally supportive of financial innovation, we have yet to find a well-constructed, conflict-free structured note suitable for retail investors. As with most things in life, if something appears too good to be true, it usually is.
1J. Henderson & N. D. Person (2011). ‘The Dark Side of Financial Innovation’. Journal of Financial Economics
2 Oxford Investment Fellows using data provided by Robert Shiller. http://www.econ.yale.edu/~shiller/data.htm.
The above commentary represents the opinions of the author as of 4.19.18 and are subject to change at any time due to market or economic conditions or other factors.Print