In this week’s rerun, we revisit the asset backed commercial paper (ABCP) debacle as a reminder of a key lesson in investing – if you don’t understand what you’re getting into, don’t buy it.

The Increasing Complexity – and Masked Risks – of Wealth Management
Originally published in the Globe and Mail on April 19, 2008
By Tom Bradley

Purdy, what were you thinking? Didn't you know how complex and convoluted investment products have become? Didn't you know this would become a hornet's nest with many different interests at play and the big financial institutions playing multiple roles?

If only you'd extended your summer in Nova Scotia a week longer and missed the call. Or better yet, listened to your wife.

When Mr. Crawford's committee to sort out the asset-backed commercial paper mess stopped in Vancouver a couple of weeks ago, I went to watch the proceedings. I am lucky enough to not own any of the combustible paper, but was curious to see how the process was playing out.

Very early in the proceedings, Mr. Crawford revealed that he wouldn't have taken the assignment had he known what he was getting into. What it involves is a classic example of how the investment industry has gone overboard inventing new and often inferior ways to sell the same thing - stocks and bonds. We have become intoxicated with our own genius and the marketing hooks that go along with it.

ABCPs are a symbol of how complicated investment products have become. At the Vancouver meeting, we learned that these short-term notes were backed by securitized loans (ranging from autos to immigrant loans), leveraged super senior structures, unleveraged synthetic CDOs, and U.S. residential mortgages. And the restructuring plan adds a few new elements to the mix - master asset vehicles, senior and junior notes, a margin funding facility and, well, don't ask.

Very few people at the meeting could have understood what was said. I've been around a while and I was hard pressed to keep up. This despite the fact that the presenters did their best to methodically take us through what the products are, how they blew up and what the restructuring plan is.

Over the course of Mr. Crawford's esteemed legal and business career, the wealth management industry has come a long way, most of it good. A few decades ago, it was pretty simple. The investor paid a broker to purchase a long-term security for his portfolio - a stock or bond. Commissions were high, but the investor got access to the interest, dividends and capital appreciation without incurring continuing fees.

As we move away from that basic model, each new feature or level of complexity increases trading, legal and administration costs. Investment banking, money management and trailer fees come into the mix. And in some cases there are performance bonuses and additional costs related to currency hedging and principal protection.

That's a lot to put into a package like an ABCP, particularly with low single-digit yields on government T-bills. By the time everyone has been paid, there isn't enough extra return in the product to justify the additional risks that are being taken.

For longer-term products with greater return potential, some of these costs are totally justified. If you want to hire someone who can beat the market, you have to pay a higher management fee, and perhaps a performance fee. Certainly increased trading is done in the hope of adding value.

But the other complexity costs (structural and marketing) erode the attractiveness of a product. They result in investors getting a smaller portion of the additional return, even though they are taking all the extra risk. The investment professionals involved receive the lion's share of the premium (as was the case with ABCPs), but shoulder none of the risk.

Consider a fictitious example. The hot new product for spring - Super Secure Dividend Enhanced XYZP - holds securities that will generate a yield 1 per cent higher than a GIC issued by one of the big banks. This is done by backing the XYZP with a package of higher risk investments (including loans to Third World fish farmers). The cost of bringing this product to market, however, is 0.75 per cent, so the investor is receiving an extra 0.25 per cent return for incurring 1 per cent worth of additional risk.

If the fishing is good and the XYZP doesn't run into difficulty, there is a modestly higher return for the investor. Everyone is happy. If it's good for a long time, the sellers and buyers forget that there is any risk being taken at all.

Despite what you might think, I'm not a troglodyte. I'm not adverse to using advanced methods or hiring someone to do them for me. And I like a marketing hook as much as the next executive, maybe even more.

But in any investment structure, the majority of the extra return, if there is any, belongs to the buyer who is taking the risk.

In too many products today, this is not the case. The current generation of structured products have little or no transparency and, as a result, they mask the risks being taken and how the potential rewards are being apportioned.

As Mr. Crawford's lapse in judgment reminds us, if you don't understand what you're getting into, don't buy it.