Few of our clients own PPNs (principal-protected notes), so the recent posting on the topic may not be of much interest, but my rant has lessons that apply more generally.  Here are the takeaways. 

  • The investment bankers and marketing executives that create structured or packaged products have not invented a new source of return.  Ultimately all these products are based on a portfolio of bonds, stocks and in some cases … wait for it … mortgages.  That’s important to keep in mind because as features are added, other things are being taken away – i.e. principal protection = lower returns.  The packagers are making choices on behalf of the investor as to what tradeoffs are being made.
  • Lack of transparency has real costs.  If a product is complicated and beyond understanding, you can guarantee that there are additional fees imbedded in it.  It is logical because there are many more people involved who need to be fed – investment banking, product development, marketing, trading, risk management, legal.
  • Unless you are an industry professional, you have to factor in structural risk.  It happens too often whereby supposedly predictable structured products produce unexpected results.  For example, a protection event in the first year of a seven year PPN eliminates any possibility of a positive return.  How many holders knew that would happen?  Or it turns out that ABCPs have liquidity risk...and a whole bunch of credit risk.
  • Tax arbitrage or deferral represents added value.  There is a tax element involved with some of these products.  Either taxes are deferred or regular income is taxed as capital gains (arbitrage).  There is value in this as long as the complexity and cost isn’t too high.  We are all very focused on taxes, but we need to remember that in a 3-4% interest rate world, a tax deferral of a few years is not worth very much.  (Obviously, it’s a different story for long-term deferral – i.e. holding a growing asset for many years.)  

For almost ten years, I have been writing about PPNs (with little effect obviously).  My concerns are based on basic investment principles and apply to many other packaged products and related strategies. 

Let me finish by saying that I don’t see anything wrong with advanced investment strategies - derivatives, hedging and arbitrage.  I use some of them myself.  But they are only good if you know what the risks are and understand the factors that drive returns. 

Fancy investment products should always have the following warning label on them:  This is for professionals only.  Don’t try this at home.