The Promise and Peril of Financial Products

A few clients have solicited our feedback recently regarding financial products that have been offered to them or they have read about. The surface appeal of most of these investment opportunities lies in either a reduction or elimination of market risk, or an unusually attractive yield.

Given the market environment of the last few years, it is completely understandable that investors would be searching for products that may offer greater peace of mind or higher levels of income. Unfortunately for investors, the financial services industry recognizes this all too well.

Many financial firms drive profits by creating products that cater to whatever emotion investors are feeling at the time – playing to investor fear or greed is a tried and true strategy for selling financial products. While the promise of such products can be enticing, investors must evaluate if the potential benefits are more than offset by greater complexity and higher costs (increased complexity carries a major advantage for financial service firms: it provides justification for higher fees).

A current example of this increased complexity is structured products. Investment banks promote these manufactured securities as sophisticated tools to help investors manage downside risk, enhance returns, or achieve other investment objectives.

While a structured product might help an investor who desires a specific payout at a designated point in the future and is willing to pay another party to shoulder much of the financial market uncertainty, this benefit often comes at a high price. The following summarizes a few common characteristics of structured products:

• Complex design: Most products have a complex design, which can make analysis of pricing, risk exposure, and potential outcomes more difficult. Some investors equate this complexity with higher potential returns, when, in fact, it may only mask high fees and risk. Worse yet, investors may not understand the range of possible outcomes.

• Substantial cost:  These products tend to carry a significant markup and costs that in some cases are difficult to quantify, especially if an investor lacks the technical knowledge to analyze the underlying components of the strategy.

• Tradeoffs: In return for receiving a prescribed payout, investors must accept a tradeoff in the form of a lower return and/or limited upside potential. There is no free lunch in the risk-return tradeoff – to pursue higher expected returns, you must accept more risk. If you do not want to bear the risk, you must transfer it to other investors and pay them for taking it.

• Credit and liquidity risks: Investors are exposed to credit risk of the issuing firm. The contract is an agreement with the issuer to make a pre-determined payment in the future, and thus, it is contingent on the firm being able to deliver (during the 2008 market crisis, some investors learned a hard lesson when the issuing firm went bankrupt). Liquidity risk is another issue. Although many structured products are listed and traded on exchanges, they may be difficult to sell, especially in a volatile market.

Perhaps most important, investors who are considering a structured product or any other financial product should consider what the appeal may be and whether the same objective can be achieved by other means in the portfolio. In many cases, the strategy can be replicated at a lower cost, and perhaps with less risk.