This week’s rerun comes from April 2009. The stock market had recently bottomed and investors were particularly fearful of risk. Not surprisingly, investment products with special features that promised certainty or limited downside were gaining popularity. Yet, there’s always a tradeoff to be paid for fancy features.

‘It Will Sell’: A Tipoff for Bad Investment Products
Originally published in The Globe and Mail on April 4, 2009
By Tom Bradley

As the wealth management industry works through this bear market, investment products that promise certainty and limited downside risk are going to be popular. With guaranteed investment certificates (GICs) offering minuscule yields, stock-market-related products with “guaranteed income” and “principal-protection” will be big sellers.

I think that's unfortunate for two reasons. First, we're now in a favourable environment to take more risk, not less. And second, investors give up a lot of return for the fancy features they're buying. Such things as downside protection, tax deferral or arbitrage and convenience come with a price.

My purpose here is to illuminate some of the tradeoffs investors make when they go beyond plain vanilla.

But first some background. I developed an aversion to complex investment products and packaging about 10 years ago. I was at Phillips, Hager & North at the time and we had a number of investment bankers come through our offices pitching us on their newest creations. They wanted to work with us because we had a good brand name that would lend credibility to the products. At the sessions I attended, I always asked the same question: “Is this good for the client?” I never once was told that it was. There was some diverting of eye contact, hemming and hawing, and on a couple of occasions, the answer was simply: “It will sell.”

We once committed to working with one of the banks on a product that saved high-tech executives taxes when they exercised their stock options. We thought it looked like a reasonable idea, but as we got further into it, we became increasingly uncomfortable. We calculated that the executives could achieve higher after-tax returns without a complicated structure. Fortunately, we were able to escape our commitment honourably when the high-tech bubble burst.

From that point on, I've done research (sometimes vicariously through much smarter colleagues) on many new packaged products and rarely have I come up with a different answer to my question. What I got was a notebook full of issues.

Lack of transparency: We should always understand the basics of what they're investing in, even when an adviser is involved. But products like principal-protected notes (PPNs) and guaranteed income funds are complicated and hard to figure out. Too often investors don't know how they work, what the underlying assets are and how much they're paying.

Misalignment of objectives: A lack of understanding often leads to investors buying products that are ill-suited to their needs. For example, a 40-year-old with a 30-year investment horizon shouldn't be buying short-term stability or principal protection, no matter how appealing it sounds. A bumpy 8 per cent return is what she/he needs, not a smooth 4 per cent.

The marketing imperative: My undergrad degree was in marketing, but when it comes to product design, that area of business should play a secondary role. Sales and marketing departments want things that will sell, which means looking in the rear-view mirror. The easiest sale is whatever worked last year (I recently saw an ad for a “bear-resistant” fund). In general, marketing-driven products encourage investors to “buy high.”

Overdiversification: “One-solution” products, including some wrap funds, are convenient, but tend to be too diversified. By having multiple managers in each asset category, the product (I'm reticent to call it a portfolio) owns hundreds or thousands of stocks. Effectively, it's an index fund with an annual fee that's two percentage points higher than it should be.

Complexity risk: In many packaged products, there are so many moving parts that it's difficult to determine what risks are being taken. That complexity sometimes results in outcomes that were unforeseen by bankers and advisers (liquidity drying up; the worst bear market in 80 years; global bank failures). Other times, however, the risks have been identified, but not communicated. The creators of PPNs (the type known as Constant Proportion Participation Insurance) have always known that their notes were path dependent (i.e. if the underlying asset goes too far down in value before it goes up, eliminating any chance of a positive return). That potential outcome is never openly discussed with potential buyers, even though it reduces the value of the note.

Degrees of separation: It's best if money managers live and die with the performance of their funds. Managers should be invested alongside clients. With packaged products, that accountability gets diluted with every person that gets between the client and the portfolio of stocks and bonds.

Cost: And with every degree of separation comes more fees. When investment bankers, lawyers, traders, money managers, insurers, marketers and salespeople get involved, they need to be paid. As a result, structured products are expensive.

Who's insuring who?: There is a common misconception about fancy investment products. Too often buyers believe that someone else is paying for the insurance and guarantees. Wrong. There is no new source of return being invented. Additional costs come directly out of what is earned by the underlying stocks and bonds.

There are other issues scribbled down in my notebook – poor liquidity, misunderstood by advisers, bad names – but I'll stop there.

I liken structured products to Viagra. The industry is hooked on them because they stimulate sales. They're a specialty product that should be used by few, but are sold to many. And the buyers get instant gratification, but pay for it in the long run.