Tracker bonds and structured products
Why there is no free lunch when it comes to risk
Structured Products are designed and sold specifically as a way of hedging against the volatility of the stockmarket and as a way to manage investment risk.
Many of the most popular structured products are designed to protect either some or all of the principal investment. That means no matter how bad things get, you won't lose your entire investment.
This appears at face-value to be the elixir of investment management for many clients: a product which captures equity-like returns, but with some capital security or capital guarantee. Surely this is too good to be true?
This video explains some of the important issues for prospective investors to consider
The subject of investment risk for many people is considered a “bad” thing. Many investors therefore naturally tend to be attracted to products offering some form of a capital guarantee.
Is investment risk really such a “bad” concept for an investor?
While the strategy of reducing short-term equity volatility via the use of some form of financial engineering or derivative strategies appears to make sense in theory, over the longer run analysis indicates that it will tend to eliminate the point of owning real assets such as equities in the first place, which is their higher expected return.
The equity risk premium is the compensation investors require for the short-run variability or volatility of equity returns. Investors who attempt to limit the downside volatility by continuously owning options to sell equities will rapidly discover that the cost of such an insurance scheme will average out higher than the return from equities.
Typically, Structured Product manufacturers attempt to evade these costs by executing what are known as zero cost option strategies, in which some of the potential upside in equities is given away via the sale of call options, the proceeds being used to finance the purchase of put options.
However, because the positive return from equities is very unevenly distributed from year to year (due to the volatility that is trying to be hedged away), such strategies drastically lower longer-run returns.
The reason for this is that the excess positive returns from equities in good years make up for lower returns in poor years. This is the compensation required by an investor for the risks taken. In addition, the popularity of such option overlay programmes is such that index puts are typically more expensive than the equivalent call.
To illustrate this point, Barclays Capital calculated what UK equity returns would have been since 1899 had such a typical option protection strategy been employed.
It is probably little surprise to find that the option-protection strategy almost completely
eliminated the equity risk premium. While unprotected equities returned a geometric annual average of 5.2%, 1899-2005, the option-protected strategy delivered just 1.4%. Over the same period, gilts delivered 1.2% and cash returned 1%.
Thus, history shows that the employment of the type of zero-cost option protection
programmes that are currently very popular with Structured Product providers would reduce the realised equity risk premium from 4% to all of 0.2%.
The moral of this particular tale is that attempts to eliminate equity risk will also eliminate the equity risk premium.
Equities outperform because their returns are more volatile than many other asset classes over the short run. Trying to hedge out these risks will hedge out the return as well; there is no such thing as a perpetually free lunch.
The analysis adds up to the basic point that the volatility of asset returns is actually the investor’s friend, not their bane. For without volatility, there can be no excess return.
Equity volatility can perhaps be more usefully described as an uneven distribution of returns over time, for which markets appear to provide an excessive compensation.
Attempts to curtail the volatility of equities by options hedging are likely to eliminate excess equity returns over time, suggesting that the investor would have been better off investing in other less volatile assets.
Costs
Furthermore, when we look a little closer, most structured products represent poor relative value for the investor. Yet consumers are not always given the necessary information to make informed decisions about Structured Products according to the Society of Actuaries in Ireland.
One of the biggest problems is that investors are not able to assess the real charges. Due to the non-transparent nature of the products, the charges are concealed. Furthermore, many investors do not consider the cost of the guarantee in their investment decisions.
The producer of the Structured Product will generally be taking charges of between 3% and 8% of the total amount invested in the product which when considered over the typically short duration of many products, represents a considerable reduction in yield.
The terms of each issue vary, but will usually be for a minimum of several years and no withdrawals can be made during the term of the product resulting in both an inflexible and illiquid contract.
Dividends
Even if the return of a product is linked to a stock market index, the investor does not receive any dividends from the shares that make up the index.
Over the long term in a developed economy, dividends from equities have historically made up a significant part of the total return from a stock market investment.
A study in the USA by Ibbotson Associates into “Stock Market Returns in the Long Run”, concluded that the bulk of the long term return of the market is attributable to dividend payments and nominal earnings growth (including inflation and real earnings growth).
This suggests that the underlying share prices would have to fall significantly for the capital guarantee on a structured product to be worth anything at all.
Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset (e.g., commodities or equities etc), an index or other items.
The main types of derivatives are: forwards (which if traded on an exchange are known as futures); options ; and swaps. Derivatives can be used to allow risk about the value of the underlying asset to be transferred from one party to another – known as Hedging.
Derivatives can also be used to acquire risk, rather than to insure or hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset.
Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made unauthorized investments in futures contracts and collapsed the Bank.
Credit Default Swaps, a particular form of Derivatives contract, were described by Warren Buffet as “weapons of financial mass destruction”
The collapse of Lehman Brothers and the heightened awareness of Counterparty risks in structured products that this created all lead to the inevitable conclusion that Structured Products should be carefully assessed before any investment is considered.
“Never invest in any idea you can’t illustrate with a crayon” – Peter Lynch
At the very least these questions should be asked by any investor considering investing in a Structured Product:
1) How is this money going to be invested?
2) Do I understand how the product will generate returns?
3) What would cause me to lose money?
4) Can you get the same or better results from a less complicated product?
The elixir of investment is always going to be the best risk/return trade-off and equity volatility is likely to remain an undesirable property for some investors. The more efficacious approach is to diversify into other asset classes whose returns are both positive and uncorrelated with equities.
