Are Structured Products Trash?

oscar_the_grouch

I am not a fan of structured products.

For those of you who haven’t wasted hours of your life ruminating on the pros and cons of financial engineering, structured products are sold to investors as a custom package of risk exposures.

For example, you might buy a note that promises a guaranteed minimum value and potential upside participation in an equity index’s return. This is equivalent to being long a zero coupon bond and a call option on the underlying index.

Or, you might buy a reverse convertible that pays a fat yield in exchange for exposing you to downside equity risk. In this case you are long a bond and short a put (you are shorting volatility).

Here’s my beef with structured products:

  • They’re expensive.
  • Most banks are better than you and me at pricing options. The deck is stacked against us (this is not to be confused with the common misconception that the bank is on the other side of the trade when you buy a structured product–issuers hedge out their exposures).
  • Because structured products are such profitable products for banks, they have fat commissions attached to them and are often foisted on unsuspecting retail investors who have no idea what they own. For example, it’s easy to sell Yield! to unsophisticated clients (and some sophisticated ones, too).
  • Oh, by the way you’re an unsecured creditor of the bank, which is one of those things that doesn’t matter until suddenly it matters, and then it’s the only thing that matters.

Before I wrote this post, I solicited some feedback from folks on Twitter. I wanted to know: do you see any legitimate uses for these products? The responses I received boiled down to the following:

  • It can be difficult for individuals and institutions to replicate their desired exposures directly in the options market for structural reasons or due to governance constraints.
  • At times, banks screw up on pricing, or there’s an opportunity to put a trade on that’s so attractive it justifies getting your face ripped off on pricing (as one individual put it: “an obviously suboptimal implementation [may be] the best available implementation”).

Taking this all into consideration I’ll modify my stance on structured products somewhat. If you are good with options, and are able to decompose these structures to judge whether the embedded options are cheap or expensive, it may make sense to dabble in structured products. I certainly don’t begrudge anyone a clever way to make a buck. In fact, it warms the heart to know clever people have made a few bucks beating Wall Street at its own game.

Likewise, if the design of your portfolio absolutely, positively requires options exposure, and structured products are the only way to access that exposure, perhaps it makes sense.

But I suspect most of us are better off without them.