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Makin' Money

A timely warning

Chris Farrell Jun 9, 2011

It sounds like a good deal. Invest in a structured financial product that protects the principal value of your money while letting you participate on the upside. It’s a particularly attractive idea considering all the volatility in the stock market and uncertainty about the future direction of interest rates.

Of course, there are all kinds of structured financial products. But the basic idea is the same. You invest your money into a product that comes with a soothing phrase like “principal protection” and “capital guarantee.” The return on the investment changes off a certain index, such as a Treasury bonds index and the S&P 500 index. So, if the value of the underlying index goes up you get some of the gain and if it goes down your principal remains safe. What’s not to like?

Lots. Problem is, these are extremely difficult products to understand with lots of exceptions and fine print. They are also expensive to own.

At a recent conference on life-cycle investing and saving at Boston University School of Management May 23-25, Nobel laureate William Sharpe warned against such products. “Good luck with structured products,” he said during his talk. “I’ve read them and after going through 87 pages I still can’t tell what they’re charging.”

Remember, Sharpe is a giant in the field of finance and known for his math acumen.

The Securities and Exchange Commission’s (SEC) Office of Investor Education and Advocacy and the Financial Industry Regulatory Authority (FINRA) have issued an investor alert on products like this. They specifically target “Structured Notes with Principal Protection” although I think the underlying point holds for all similar structured financial products..

The bottom line for investors is that structured notes with principal protection can have complicated pay-out structures that can make it hard to accurately assess their risk and potential for growth. In addition, depending on how the note is structured, the distinct possibility exists that you could tie up your principal for upwards of a decade with the possibility of no profit on your initial investment. While your principal might be returned at maturity, that might be all you get back after this lengthy holding period–and, in the meantime, inflation could erode your purchasing power.

Think regulators and Professor Bill Sharpe are kidding about complexity? Okay, look at this example the regulators use to highlight their concerns. It’s a so-called “shark fin” pay-out structure. Here are the main assumptions:

  • Principal protection of 10 percent of initial investment
  • 100 percent participation in index gains up to 40 percent, so the maximum return is 140 percent of principal
  • Automatic 110 percent return at maturity if the index gains more than 40 percent at any time during the life of the note

Got it? Here’s a chart of how the product works.

Confused? This table gives you examples of how changes in the underlying index would affect your return.

There is no such thing as a free lunch. Products like this are good for the seller’s bottom line. But for the buyer the old investment warning holds: Caveat Emptor (or as I like to say, Steer Clear!).

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