Structured Products – They’re not for everyone, but you shouldn’t just dismiss them!

Before you start, this one might not be for the fainthearted. I’m writing this in response to an article I read entirely dismissing structured products. In my response I’ve tried my best to simplify as much as possible what are, by their very nature, complex products in the hope of persuading you that there are 2 sides to this conversation. While a lot of these products should not be touched by individual investors, sometimes and in some circumstances they could be of use for the individual, so long as they properly understand what it is they are buying. As a result I hope to make the point that making a blanket stay away message on any financial product should at least show the whole picture to let investors make their own minds up. Now with any luck I haven’t scared you off too much before you start! On the contrary, I hope I’ve encouraged you to expand your knowledge, so please read on!

                         Earlier this week I stumbled upon an article written for MoneyWeek telling people to steer completely clear of structured products (“Don’t fall for structured products”). That no one should invest in them ever because they are all rubbish and the investor would always lose out. The author based her complete dismissal of all of these products on a couple of new products she’d been sent which she deemed to be too risky to even think about, because mostly there was too much downside potential for the investor with a very limited upside. Whilst I believe she had a point in reference to the two products she mentioned, it struck me very much as being a severe case of using two bad examples for the purpose of dismissing everything in that field. It’s a bit like telling me I should keep my money under a mattress because the 2 savings accounts I looked at give 0% interest and are both at nearly bankrupt banks, so as a result there’s no point saving in any savings accounts (although some might argue at the moment it’s just as effective!). In reality what you’d do would be to look out for the best account for you which offers the best return. All financial products are essentially the same from that respect.

               

                         Now I’m aware that a large number of the people reading the blog will be wondering what on earth I’m talking about when I speak of structured products. Sure, I well know my family and most of my friends used to look at me confused when I mentioned I worked with structured derivatives. They still came out wondering what it was I did when I tried to explain. But, for the hope of not boring those already in the industry, I think it’s worthwhile to give those not in the know a brief overview. 

                     In relatively simple terms, a structured product uses derivatives on a mixture of different assets to create a tailored payoff for the investor. This mix of assets could include anything (bonds, equity indices, individual stocks, fx etc.). Most of you will probably have heard of some of the more infamous structured products which assisted in bringing about the financial crises – Mortgage Backed Securities (MBS), Collateral Debt Obligations (CDOs) for example - and in it you can already see some of the dangers of certain of these products. The specific types of structured product discussed in the money week article however are what are known as equity structured notes.

                  Equity structured notes themselves can take many forms, but it effectively will give you a payoff linked to the performance of a single equity or index or a group of equities/indices over a period of time. The main benefit of these products is that they will sometimes offer to protect your capital somewhat (in a process known as capital protection) through selling you a bond as part of the structure. (It’s important to know at this point, that this capital protection is provided by the institution that is issuing the product, so there is a risk there.) These products can range massively in complexity from the simple ones, offering you only the upside on the performance of an index, or they can be extremely complex, involving all sorts of caveats as to what your return will be based on. There are whole books written and still to be written on these, but hopefully you have the very basic gist. As you can see, even from the off they’re not for everyone!

                  The moneyweek article focused on 2 particular products both of whose payoff was on the slightly more complex side for a basic investor. In them, the investor only got a small coupon each quarter from their investment and even this was dependent on all 3 stocks used in the product performing positively over the 2 year timeframe. If all 3 shares fell by more than 20% in that time, then you stood at risk of losing some if not all of the capital you put in (although to lose all your capital HSBC, BP and Vodafone’s share price would all have to fall to 0, an apocalyptic thought for any pension fund holder!). As you can see, a product of this kind has inherent risks and this is one where the upside certainly doesn’t seem to necessarily compensate for the downside. So if you were now interested in either of these products as a private investor I’d suggest you read what I wrote a few weeks ago on the difference between speculation and gambling so you can decide which it is you are doing and whether blackjack is more suitable.

               But they’re not all this complex. What if you could buy a structured note which pretty much guaranteed your capital 100% and also gave you a 55% coupon after 5 years? All that you’d need would be for the FTSE 100 to be above what it was now in 5 years time, just by 1 point. If it is you get your money back as well as 55%, if it isn’t then you get the capital you invested back. Or alternatively what if you similarly were offered a coupon of 4 times the performance of the S&P 500 over the next 5 years up to a maximum of 80% with your capital similarly protected should the S&P 500 finish below the current rate? There’s certainly reasons not to take these products. After all, the FTSE 100 may perform better than 55% in that time frame and you’ve then lost out so in theory you would have been better off buying directly into a FTSE 100 tracker and holding it for the 5 years. If the S&P 500 finishes below today’s level then you only get your money back with no return effectively eroding the value of the money you had when you could have just put it in a savings account and at least earned some interest. But therein as always lies the benefit of hindsight. As an investor, we could always have made more money if we had a time machine.

                  If I had offered you these products 4 years ago in 2008, with all the uncertainty that was around then, there’s a fair chance that some of you would have found these quite appealing. Barclays offered these exact products back then and they wouldn’t have been the only ones. Markets were trading near lows not seen since 2003 with the FTSE around the 3600 mark and S&P around 700. There was uncertainty as to how much they were likely to rise in the next few years and meanwhile with interest rates approaching or already at their all-time lows there was not much to be returned by keeping your money in a savings account. Given all that uncertainty, some investors may have assessed that markets were going to go up, but it was difficult to see how much, and there was the possibility that in 5 years time they could be near to where they currently were. You’re afraid of losing your capital if you invest directly in the market, so the capital protection element gives you comfort around that, (assuming you have faith the institution issuing will still be around then). In addition the prospect of a 55% return should the FTSE have been even 1% above its level at the time is a better prospect than only 1% by just sticking your money in a FTSE tracker. So for an investor who had a mildly positive view on the FTSE 100 over that 5 year period, but wasn’t so convinced on the size of the upside and also wanted to protect his investment, this may have suited him. It offered some kind of security and the potential for a decent return of 55% so long as the FTSE was in even a small element of positivity after the 5 years. There are plenty of this type of product available today from various institutions.

But of course there are risks, after all there’s no such thing as a free lunch!

• Loss of upside: On the simplest level you may feel you’ve protected yourself against any falls, but you’ve also limited yourself on the upside. However as a cost of giving yourself protection, you have to accept that you won’t be able to take advantage should markets really take off. It’s the choice you make. In the end, you want to make sure you get the return you are aiming for. So long as you’ve done that then there should be no regrets.                                                                                            
• The Capital Protection Risk (Counterparty Risk): As I alluded to before, the capital protection is only as good as the company which issues the note. There’s no sure thing in this world, and you need to know who is telling you they’re protecting your money because if they go under then your money goes under. It is estimated that investors held in the region of $18bn worth of Lehman Brothers issued structured products when they declared bankruptcy! Those investors now need to queue up with all the other creditors to see what they’ll get back. It’s important to assess who is guaranteeing your capital but, as Lehman proved, nothing is assured.                                                                               
• Liquidity Risk (The ability to sell): In theory the structured products that individual investors can buy are tradeable on the market, so the investor can sell the product as and when they want. In reality however there are only a limited number of each note issued each time, and the ability to sell is, as with any security, based on the willingness of someone to buy. As a result whilst there is a market on offer, if things don’t turn out as you’d hoped and you want to get out before the note reaches the end of its life, you may not get back as much as you’d hoped.                                                                    
• Complexity: As I mentioned much earlier, structured notes can be very complex. Even notes which appear to offer a very simple payoff at the end may contain several features whereby your capital may be affected should the index or underlying share hit certain levels. Like an antibiotic, always read the label. You want to make sure you’ve read the entire termsheet and all the caveats so you know what will happen to your money! Don’t just be taken by the high potential return offered if you can’t figure out how you get there. Even if you can understand it, it doesn’t necessarily make it a good investment compared to a simpler solution. 

                   As you can see from all of this, these products are certainly not for everyone and in some cases it’s debateable whether the risks make them suitable for any individual investor. They can b complex, but it doesn’t mean you shouldn’t try to educate yourself to understand them. There are times and in certain situations where there is the potential for an individual investor to make a true risk assessment on an equity structured note and deem it to be a better fit to his/her risk profile at that moment in time than a straight investment into an equity or equity index. That is the decision for the individual investor to make. I’m not a financial advisor, nor do I claim to be offering financial advice. I’ve previously spent 8 years working with structured equity traders so I probably have more knowledge on this than most of the general public but I stand to make no money by explaining them. Are they suitable for everyone? Certainly not. Are they suitable for most people? No way. But that doesn’t mean you should just reject them out of hand. Everyone deserves to understand a bit more of what they’re being told to steer clear from so they can make their own decisions. Hopefully I’ve gone a little further in doing that!

Much ado about nothing?

            It's got to the end of the week and I've decided to write this week's article about nothing. Well, not quite nothing, but the fact that nothing's really changed in the last month. That no matter how much the financial media and the markets might want to scrutinize, examine the tone of, or rearrange what's been said by Fed chief Ben Bernanke, nothing he said at various times differs from what he first stated on June 19th.

Bernanke Praying for the markets and media to just understand what he's saying!

       To briefly recap on his statement back then, he stated that if the economic data is roughly consistent with the Fed's forecast, it could then be appropriate to moderate the pace of purchases later this year through to the first half of next year, potentially ending purchases around mid-year 2014. But, no one should draw the conclusion that the policy is to end purchases in the middle of next year, because the purchases are tied to what happens in the economy. If the economy does not improve along the lines that they expect, then they will provide additional support.

           A few weeks later Bernanke followed this up in a Q&A session on July 10th. He reiterated that interest rates were not going to rise in the immediate future until unemployment was below 6.5%, inflation was under control around the target level, and even then only if the economy itself was showing sustainable signs. But he also said that there was a mix of instruments involved, and that asset-purchases (QE) was the other component than interest rates, indicating as he did the previous month that this is what would be reduced first. However, what he also stated was that, "highly accommodative monetary policy for the foreseeable future is what’s needed in the U.S. economy". This was, according to the media and markets reversing track on what he had said in June and encouraging the stock market at least to hit the same levels as June 18th.

          Then over the last couple of days while giving his semiannual statement to congress he mentioned that there was no "preset course" for ending QE and that any change would depend on how the economy was doing, stating "What we’re looking for is a pick-up as the year progresses. We’re going to look at the data. It’s a committee decision. It’s going to depend on whether we see the improvement which I described.” This time, finally, the market (and media) translated this as him actually saying they won't take action until the economy is strong enough to support it, with the S&P 500 hitting a new record high of 1,693.

            So just to clear it all up in case you weren't listening........

June 19th: Bernanke tells us all that should things improve to the targets as projected they'll ease off QE but only if things do indeed get better and there is no set policy. Market Drops and analysts and media throw a tantrum.

July 10th: Bernanke states there are targets to get to. Not to assume it will happen or assume there is a set policy. Market begins heading upwards and media tells us he's backing down.

July 17/18: Bernanke repeats that there are targets to get to. Not to assume it will happen or assume there is a set policy because it all depends on the data. Market hits new record high and media laud softening of his stance.

From where I'm sitting, nothing's changed in what's been said, only the media and investors have decided that he's changed his mind because of their tantrum.

       Imagine a child wanting to go and play football with his Dad. "Dad, can we go and play football?". "Sure", the Dad says, "In an hour once I've finished mowing the lawn". The kid tantrums and screams to his father, "It's not fair, you won't play football with me". The father responds "Don't worry, I will play football with you, I just have to finish the lawn first". The kid starts to perk up "Can we play football now?", "Sure", says the Dad, "I'm nearly finished so we'll play shortly". The kid is now happy as he waits for his Dad to finish.

        Sometimes you have to tell a child something a few times for them to understand what you said. You may need to slightly change the wording each time, just like the father above to get his child to understand. It's not that he won't get to play football, he just has to wait for the grass to be mowed first. That's a kid. A kid is growing, learning, needs simple things explained sometimes. Here we're talking about  supposedly knowledgeable investors and media analysts. You might expect a kid to misunderstand a clear statement, to interpret it in a different way when it's first mentioned and then change his interpretation when the same thing's said again.

        Bernanke repeated the same agenda 3 times in the last month. Nothing's changed, it seemed pretty clear first time round. Yet unfortunately there's a big kid out there who either doesn't listen or tries to only hear the bad side without listening to the good (or sensible) of what they're told first time around.  So he's got to repeat himself in a different way so they understand. Do they understand, I'm still not convinced they do. The kid needs to learn quickly that there's a straight talking agenda and all they need to do is listen properly. That way the tantrum won't be necessary and they (and we) can breathe easier. I guess it's just all part of growing up in a new world.

S&P 500 19th Jun-18th Jul (c) Bloomberg

Forward Guidance - Forward Thinking or Increasing the Pressure?

            Last Thursday 4th July, the FTSE 100 rose by over 3% in just one days trading. Given the current  irrationality of the markets, one could have been mistaken for believing it was a display of national exuberance with the markets making a prediction of Andy Murray ending Britain's Wimbledon hoodoo. The movement however was rather in response to the opening performance of a Canadian, and it wasn't Greg Rusedski.  As has been widely spoken about, Mark Carney became the first foreigner to become the Governor of the Bank of England (BoE), the body in charge of monetary policy in the UK. Last week represented the first interest rate announcement following his taking on the role and with it brought in a new era in how the BoE seems certain to conduct itself in the future.

           On the first Thursday of every month the BoE announces the base interest rate, and has historically only provided a statement with the announcement if there was a change to the rate, or as has been the case more recently, if there has been amendment to the size of QE or other changes in policy. This month, for the first time there was a statement released despite there being no change in policy as the BoE prepared the UK and the markets for the start of forward guidance. Forward guidance is when central banks indicate potential future monetary policy with reference to their projections for the economy. This is in contrast to how the BoE (and many other central banks including the ECB) has previously operated in purely announcing the policy decisions for that month with no future indications of when rates may change or QE may end (or whether in fact it may increase).

         There has been a lot of debate in the markets and the media over the positive and negative effects of having a forward guidance. Criticisms have included the fear that if the predictions made turn out to be inaccurate then the credibility of the central bank is put at risk, with investors losing trust in their ability to have an impact on the economy. Other worries are that statements could be misinterpreted by the markets causing damaging asset movements, such as pushing up the bond yields in a country, which ultimately could have a negative impact on the economy. This, ultimately, could then lead to the banks projections failing to be fulfilled and thus leading to a credibility problem. I spoke about one of these previous market misinterpretations in the reaction to Bernanke's forward guidance in the post a couple of weeks ago whilst there was a similar misinterpretation (and sell off) when Australia's chief central banker attempted to introduce a bit of humour into the Reserve Bank of Australia's decision to keep rates the same.

          There are more positive sides to having such a transparent and indicative process and I believe these outweigh the potential risks. In most walks of life it is fair to say that communication and how things are communicated can be a crucial difference between success and failure. By giving the market an indication of how they believe the economy is likely to perform in the next couple of years, and giving guidance as to the use of the tools being considered over that period gives the markets a clarity which should only assist them in their forward thinking. The uncertainty as to what a central bank might do has often had drastic consequences on assets which in itself have caused a damaging effect on the economy and potentially led to central banks acting in a manner which they had not previously planned to do. Removing this uncertainty should hopefully remove such potential volatile reactions.

             This is becoming increasingly important now for the BoE as there begins to be a divergence in the performance of the US economy with that of the other economies. Previously the markets have been able to work on the assumption that the US, EU and UK are all working in the same direction and that all their central banks will continue with loose monetary policy in order to assist in getting their respective economies out of the doldrums. Now, with the Feds most recent announcement (using forward guidance) that they could consider stopping QE in the US, should the economy recover as they expect it to, it is important for the other central banks to provide clarity to their own positions with similar transparency. UK Gilt Yields had seen a similar rise to their US counterparts following Ben Bernanke's speech indicated to the markets that there was a risk of rising interest rates in the future. This despite there being no indication that the UK was going to do the same. Mark Carney's first monthly rate decision statement thus quickly served to separate out the BoE's policy from the Fed stating "The significant upward movement in market interest rates would, however, weigh on that outlook; in the Committee’s view, the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy." This served to ease the upward pressure on Gilt yields causing them to drop slightly off the back of the BoE drawing attention to the fact that the UK is in no current position to follow the example of the US and begin thinking about tighter monetary policy. The statement pointed to the fact that although "recovery is in train...it remains weak by historical standards and a degree of slack is expected to persist for some time." It was no coincidence that Mario Draghi of the ECB indicated they too would also look towards giving forward guidance in the future.

            All of this should only be seen as only a positive step by investors and indeed by the media. What is important however is that the predictions given by the BoE (and ECB) are seen as purely that, predictions. Looking back at thing in hindsight by others is often the end for those who try to make accurate predictions for the future. The media especially are quick to pounce upon those in positions of power to remind them of what they predicted when it turns out differently. It is important to remember that the predictions are based on the data and projections available today and are purely used as a guidance as to what is perceived as the likely outcome, and how monetary policy will be reflected should that reality occur. That's why it is crucial that both the media and investors concentrate on what is actually said as opposed to what they want to try and interpret from the words (potentially for their own ends).

        There was an interesting research paper posted by the ECB which I read at the weekend entitled "Loose Lips Sinking Markets". The paper found that the yield spread of both Irish and Greek sovereign bonds over the German bund at the height of the euro crisis (2009-2011) was affected by comments made by both national politicians and international actors, such as ECB board members. Moreover what was also discovered was that negative comments, even by relatively minor politicians, had a more damaging impact on the yield spread than the positive impact of upbeat comments. Mark Carney has arrived in the UK with many investors and indeed the media looking at him as being the savior with the ability to pull out all the tools necessary to help guide and shock the British economy back to prolonged and effective growth. However he only holds some of the tools. A big assistance in managing this also lies with the politicians. In the UK especially, fiscal policy is going to play an important factor in getting the UK back to health (more on this in another blog). As the aforementioned paper demonstrates, the words of politicians (on all sides of the political spectrum) in addition to those of the financial guardians could have crucial impact on not only the behavior of the markets, but also as a result the behavior of the economy. The media (and investors) also bear responsibility for ensuring that there is no overreaction to a slightly adverse economic indicator or indeed a flippant or point scoring comment from an opposition politician.

                The last Canadian to arrive on these shores with such an expectation to bring back success to the UK ended up a US Open finalist, but ultimately couldn't go that final step of the way to bring cheer to the country. Greg Rusedski at the time was able to share that burden of expectation of the nation with Tim Henman, himself only capable of a string of semi-finals. Mark Carney will need to hope to share his burden with George Osbourne, for now at least. If I were to offer Mr. Carney some advice (in case he was looking for it), it is likely he will learn soon enough the UK media's love for building someone up to the top only to try and displace him in the cruelest way possible should they not be able to quickly provide the success required. I would hope this doesn't dissuade him from his efforts to provide more clarity and forward thinking for the way forward for monetary policy in the UK (He might also want to avoid using humour given it's consequences for his Aussie counterpart).  As for being able to deal with the expectations of a nation being placed on one man's shoulders and succeeding, well I suggests he gives Andy Murray a call.

Bringing Down the House – When is it fair to label Speculation as “Gambling”?

                 This past week I stumbled upon an old book from Uni creatively called “Investments” by Bodie, Kane & Marcus (5^th Edition McGraw Hill Irwin Publishers – in case you’re interested, or in case they’re reading). As I flicked through it I came across a section which discussed risk, speculation and gambling and I was intrigued. After 8 years supporting various trading desks I thought it might be interesting to see how the literature determines the difference between speculation and gambling.

Speculation is, to quote the section (p.156):

““the assumption of considerable business risk in obtaining commensurate gain”…………By “commensurate gain” we mean a positive risk premium, that is, an expected profit greater than the risk free alternative”……….by “considerable risk” we mean that the risk is sufficient to affect the decision. An individual might reject a prospect that has a positive risk premium because the added gain is insufficient to make up for the risk involved”.       

Gambling on the other hand is defined as:

“”to bet or wager on an uncertain outcome”…………Economically speaking, a gamble is the assumption of risk for no purpose but enjoyment of risk itself, whereas speculation is undertaken despite the risk involved because one perceives a favourable risk-return trade-off. To turn a gamble into a speculative prospect requires an adequate risk premium to compensate risk averse investors for the risks they bear.”

      That last line for me is the most interesting because it suggests a fine line between gambling and speculation, and one which implies some level of one’s perception is the only difference.

                    Ever since I started in working in banking I have been asked by friends and family not in the industry “isn’t trading on the stock market just gambling?” More often than not I took the official approach – investors are taking informed decisions based on the information out there to take a calculated risk in determining whether a stock was going to go up, or down, and as such this enabled them to verify whether the risk premium involved outweighed the risk. Most people at that point nod politely (or nod off!) and admit they don’t understand the market and figure that other people must have more knowledge to be able to make truly informed decisions.

                 As the definition above lays out, in order for a trade to be truly speculative as opposed to a gamble, you need to determine an expected return based on the probability of a variety of outcomes on that trade, using all the information available, and not only for this return to be above the risk free rate (normally seen as being either US Treasury rates or in this country UK government Gilts), but also for the additional risk involved to be adequately compensated by the expected return above that rate.  

                  Of course to make that decision and not feel like you’re “taking a punt” you need to feel that you have assessed all the relevant available information. You then of course have to realistically assess the risk of successful and non-successful outcomes. If you’re looking at a longer time horizon, say 10 years, for your investment, then you have a decent time frame to realistically consider your potential investment’s risk vs reward profile and perceive yourself to be making an informed investment based on information you've gathered and that supplied by others.

          But what about on a day to day basis? Can we really say it’s possible to properly ascertain the risk versus reward in the very short term and conclude that on the whole we are making a speculative investment and not just a gamble i.e. we have perceived the risk premium to adequately compensate for the risk involved. I would say, at the current moment this seems unlikely in most cases. We’re currently living in a world where the market falls at an indication things might improve, rises when the economy performed worse than originally thought, but then can rise or fall when other economic indicators indicate improvement. 

        As I've mentioned in previous blogs a rational investor would surely have expected a rise in the S&P 500 off the back of the Fed announcement. But Let’s say you took the contrarian view. You “speculated” based on the information you felt you knew that the S&P 500 would go on a downward spiral for the next couple of weeks? After all if you felt that Fed tapering was bad news surely the closer this comes to being put into action then the more the market should fall. As a result you sold on the day of the news, June 19th. Well even then you’d most likely be disappointed with the market falling slightly again for the next few days but effectively as of the close last night it was only slightly below the closing level of June 19^th. So you’re almost back to where you started but you’ve also used resources in potentially going from previously being long to now being short as well as incurring transaction costs. Speculation of course doesn't mean you’re always going to be right and make money, but can an investor really make very short term perceptions as to market behaviour and risk/reward payoffs in the current topsy turvy markets and still call it speculation?  

        

              A few years ago I read a book called Bringing Down the House, by Ben Mezrich, in which he tells the true (well close to true) story of a group of pretty smart MIT students who have a remarkable ability to count cards to a high degree (There was also a film starring Kevin Spacey called 21, but the book was better). This group led, by their university professor, go to casinos around the country, and ultimately to Vegas, hitting the blackjack tables and raking in millions of dollars. Their biggest risk was non-financial – they had to hope to avoid physical intimidation should the casino ever cotton on to their method. It was a short term speculative investment which they knew they had a good probability of coming good from. The big difference here is that they knew all the elements and were able to produce a strategy which had winner written on it most of the time. 

            There is no such strategy or methodology attributable to the current markets in the short term. When good news could mean up or down then speculation cannot be possible. If you’re looking at an everyday individual investor and they think about the medium term, at least 4-5 years, it’s fair to say most people will be close to speculative in how they invest their money in the market. But try to “speculate” on a daily, weekly or monthly basis, you might find you’re just struggling to count cards in Vegas. The problem is you don’t know how many decks of cards they’re using!!