Investing is perilous enough when investing in stocks and bonds or even in plain vanilla mutual funds, but it can get downright dangerous with the increase in complexity of many financially engineered investment products. Following the 2007 subprime mortgage meltdown, which affected both Main Street to Wall Street, a lot of blame was being spread around about who or what was responsible. While the meltdown resulted from a combination of factors, many argue that the complexity of the derivatives products, which were developed from relatively simple mortgages, was a major contributor to the subprime crisis.
By slicing and dicing a mortgage, financial engineers created an array of investment products like mortgage-backed securities (MBS), asset-backed securities (ABS), collateralized mortgage obligations (CMO) or collateralized debt obligation (CDO). These exceedingly complex products are so opaque that very few people really understand them and how they work. Investors, the credit rating agencies and even the big banks and brokerage firm all failed to understand the risks of these investments and all were burned by the following collapse. This outcome should serve as a warning for those investors contemplating the purchase of complex investments. (To read all about the credit crisis and mortgage meltdown, see The Fuel That Fed The Subprime Meltdown.)
Underlying all structured investments are securities that are part of the capital markets. The risk and the performance of structured investments are inevitably determined by the investments upon which these complex securities are based, not the financial engineering. (To learn more about structured products, check out Are Structured Retail Products Too Good To Be True?)
Complex investments may have risks that are not apparent, or easy to understand. As a result, it might be difficult to determine how the investment will make money. For example, when an investor buys a simple equity mutual fund, the investor will make money if the market goes up. However, in a fund of hedge funds it is next to impossible to determine how the investor will make money. It is essentially unknown. Similarly, principal protected notes (PPNs) are also derivative products, an they include a combination of guarantees and embedded options. As such typical investors have no understanding of how to evaluate a PPN. They do not know whether it is a "good" investment or if they are paying too much for the product's underlying features.
The more complicated the product, the less transparent the risks. This was made apparent by the subprime mess. Many investors might have understood the potential for a poor real estate market and the possibility of foreclosures. However, while many investors owned securities that were based on subprime mortgages, they were unaware that these securities were so vulnerable to a poor housing market. As such, they were not able to make the connection that foreclosures in Cleveland, Atlanta or Los Angeles would negatively impact the investments they purchased locally.
Buying simple products tends to be much less expensive than buying more complex securities. For example, buying 1,000 shares of a $100 stock might only cost $10 for the transaction with an online broker; with a discount broker, the annual cost of owning the stocks may be $0. Similarly, exchange-traded funds (ETFs) are simple and inexpensive. For example, in 2008, the iShares S&P 500 ETF has an annual management fee of only nine basis points (or 0.09%). If you have this product in your portfolio, a $100,000 dollar investment will only cost you $90 per year. On the other hand, when you buy more complex products like variable annuities or principal protected notes, they may appear inexpensive, particularly if they don't have any upfront fees or commissions; however you are paying for the products, and they are very profitable to both the advisors who sell them to you and the company that created them. In such cases, the fees are built into the structure of the products, and are therefore not readily apparent to the consumer.
The companies that manufacture and manage complex products understand them far better than the client who buys them. Asymmetric information exists when sellers know much more about a product or a service than buyers do. For example, used car salesmen have more information about a specific car than the individual who is buying it. When sellers know more than buyers, it creates a situation in which unsophisticated buyers may pay more for products than they are really worth. In addition, the more complex the information about a product is, the more an unsophisticated buyer is willing to pay for it.
In Bruce Carlin's research paper, Strategic Price Complexity In Retail Financial Markets, one of the conclusions was that "consumers … often make purchases without knowing exactly what they are getting or how much they are paying. In fact, they may also be unaware that they are indeed overpaying". In this paper, Carlin implies that firms deliberately make their products complex "thereby gaining market power and the ability to preserve industry profits" (December 2006, Social Science Research Network). (Comparing price swings helps traders gain insight into price momentum. Learn more in Divergence: The Trade Most Profitable.)
In Carole Bernard and Phelim Boyle's research paper titled Structured Investment Products And The Retail Investor (April 2008, Social Science Research Network), it says "consumers often select a complex product when a simpler one is preferred. These puzzles are not unrelated since some of the most complicated products are the most overpriced and carry the highest commissions." The research shows what common sense implies: uninformed, naïve consumers can be strategically exploited by producers of financial products.
It is quite likely that many advisors do not fully understand all the products they sell. Although many products are sold with a detailed prospectus, it requires a thorough analysis to understand the products fully. Some advisors might not take the time to read this prospectus, are too busy, or do not have the background to interpret the information and make sense of the product. In the end, this may mean that the advisor is unable to provide adequate due diligence on behalf of his or her clients. (Got a hot stock tip? Follow up on it with the tips found in Due Diligence In 10 Easy Steps to avoid getting burned.)
In addition, complex products generally have higher commissions attached to them, providing the advisor with an incentive to sell these products even though they might not understand what they are really selling. As such, it is important that the investor take the time to understand any product he or she buys into, rather than rely on an advisor to do all of the work.
The Investing Process
The most important place to start with a manufactured product is with the information that is provided to the buyer. Let's take a look at few investing tips to help you get started.
- Ask yourself these questions: How is the money to be invested? Can you understand how the product will generate returns? What would cause you to lose money? Can you duplicate the results in a simpler fashion?
- There is nothing to force an investor to buy an investment product he or she does not understand. If you cannot explain it to a friend, then it is probably too complicated.
- If an advisor is recommending it, ask questions. Nobody ever loses money by asking too many questions.
- If the advisor cannot explain a product adequately, stay clear. The more complicated the product, the more investment knowledge and experience you will need to buy it.
- Watch out! The most complicated products are often sold to unsophisticated and unsuspecting investors who cannot adequately evaluate them.
For complex products, "the devil is in the details". Reading the fine print about any investment product is a necessary requirement. This includes information about guarantees, about the features that limit the upside, about risks to the products, the fees and commission, and the liquidity of the product. Remember that numerical examples that are provided to advertise a product are generally presented in a way that highlights the product's features but not its limitations. Keep this in mind and don't let these examples determine your decision to buy in. (Learn a simple way to bring the benefits of derivatives into your portfolio, in Understanding Structured Products.)