Risks confined to the small print with structured products

Occasionally, investors with high cash balances in their accounts are contacted by their bank managers and advised to put the money into a high yield investment rather than leaving it where it is earning low interest. Bank managers are not being philanthropic when they call. In fact, it suits them to have customers with idle cash in their accounts.

However, they make extraordinary high commission by selling what are known as structured investments. High commissions apparently drove ACCBank to encourage customers without cash to buy structured products using borrowed money.

Sometimes, investors feel flattered if they are told that they are ready to “join the exclusive club” as ACC put it, by becoming sophisticated investors.

Structured products are similar to bank accounts or corporate bonds. What distinguishes them is their complexity. A structured bond might offer a return of 150 per cent of the stock market return with capital protected, or a very high yield as long as the euro doesn’t depreciate against the dollar etc. More recent structured products offer a very high return as long as default in a portfolio of loans is low. The brochures, of course, accentuate what can be achieved; the risks are confined to the small print.

‘Rocket scientists’

Many customers make the mistake of believing that because these products are used by wealth fund managers, hedge funds, investment bankers and successful investors, they must be worth getting into.

In reality, structured products have had a chequered history, being described by Warren Buffett, a most successful investor, as “weapons of mass destruction”. They are usually complicated, illiquid, expensive and dangerous.

The “rocket scientists” who design them are aware that customers like local authority managers and pension funds buy them using other people’s money. The products are designed so that you can simultaneously record a high accounting profit and delay the recognition of losses for a few years. Fund managers of course like to announce profits and delay losses.

However, when losses do emerge, they tend to be large in size. About 20 years ago Orange County in California went bankrupt because one treasurer played around with structured products and amassed huge losses.

According to the New York Times, “He blamed his broker, Merrill Lynch, for leading him astray.”

“I was an inexperienced investor,” said Robert L Citron, who served more than two decades as treasurer of Orange County and was the man in charge of its investments, the paper reported.

Simple investment

A simple example illustrates why some structured products are lethal.

Suppose interest rates are expected to be 3 per cent, 4 per cent, 6 per cent, 8 per cent and 9 per cent for the next five years, giving an average of 6 per cent. A structured product salesman might sell you a simple investment that pays a coupon of 5.5 per cent. He raises €1 million from you and puts this on deposit at the average rate of 6 per cent and pays you 5.5 per cent.

You will be able to show a profit for year one of €25,000 (5.5 per cent minus 3 per cent) and year two because actual interest rates are below 5.5 per cent but for years four and five you will make losses which the salesman will be a bit reluctant to reveal.

Neither will he tell you of the commission or profit he is earning which is 0.5 per cent per year (the difference between 6 per cent and 5.5 per cent). Over six years that comes to €30,000 on a €1 million investment. Some structured products have more complex coupons. For instance, if the coupon is 22 per cent – four times one-year interest rates – the profits are much higher in earlier years; for year one it is €100,000 (22 per cent minus 12 per cent) but the losses in later years and the commission are also greater.

Reveal losses

Since Orange County, new regulations have attempted to prevent similar catastrophes. Fund managers must now warn shareholders if they are using structured products and, generally, must reveal losses instantly. Banks to some extent tried to get around the rules by selling structured products to the retail as opposed to the professional investor. Although there is legislation protecting customers, banks don’t have to reveal all the losses and neither is there a requirement to reveal the commissions banks may make.

Structured products are often complicated for a reason. They allow investors to believe that they are making a profit when in reality they are taking on more risk than they realise and are also paying vast sums in hidden commission.

Avoiding middlemen

Savvy investors don’t like complexity. They want to know how much commission the middlemen are earning and then try to minimise or avoid it.

Set investment objectives in terms of risk. Decide how much risk you are willing to take on and invest in simple products. By avoiding the middleman, you are better able to measure risk or at least understand what you are taking on and then make sure that you are properly rewarded.

Experienced investors are able to manufacture their own structured products using simple derivatives, thus avoiding the high commission expense.

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* Cormac Butler is the author of Accounting for Financial Instruments and has led training seminars for bank regulators and investors on financial risk. He has traded equities and options.