Jason Zweig at the Wall Street Journal published a disturbing article that deserves more attention. The basic story is this. A number of banks sold a complex financial product to retail investors who have subsequently lost quite a bit of money. Here is the basic pitch that was apparently made to individual investors in 2012. You are going to buy an investment product that is currently invested in bonds and is producing 8% in income per year. The performance of this product is tied to the stock price of Apple, however. In exchange for the high income, you take on the risk of a decline in Apple’s stock price. These products were sold when Apple stock was soaring, so a fair number of people apparently saw this as a favorable bet. With the stock down more than 30% from its peak, many of these investors have lost a considerable amount of money. Read Zweig’s piece for more details. These products have a number of variations and he discusses one specific structure. Here is another. The title of Zweig’s article, How Apple Bit Bondholders, Too, gives the impression that bonds were responsible for these losses. This is not the case, but the title serves to illustrate the subtlety of the problem.
As the article notes, this so-called ‘structured product’ is functionally equivalent to having the buyers of this product assume the risk of a decline in Apple’s share price by selling cash-secured put options, a strategy that is not for the faint of heart. The money invested in these products would be invested in bonds (hence the title of Zweig’s piece), but the product is also short put options on Apple. This investment is not a bond, it is a bond along with a potentially major claim against those bonds. In a declining market for the asset that the put options are written against (Apple stock, in this case), you can lose a lot of money very quickly. You have limited upside potential but essentially unlimited downside. More than $700 million of these products were sold to investors in 2012. With the stock price of Apple dramatically below 2012 levels, many of the investors are currently facing a loss of 25% or more of their original investment. Granted, many Apple stockholders are deeply in the red at this point, too.
There are so many issues raised by this story that I hardly know where to begin. First, investors who don’t understand derivatives should not, in my opinion, be sold derivative-linked products which have substantial downside risk. Given that knowledge of derivatives is typically limited to those with substantial knowledge and experience, the sales of these products would be limited if my first rule applied. Second, investors have to take some responsibility here. No financially literate adult could have believed that they were buying a ‘safe’ investment with an 8% annual yield. Nothing yields 8% except very volatile equities and such yields in this interest rate environment are understood to be far from ‘safe.’
This story reminds me of an incident I experienced a number of years ago. My mother-in-law, then on the cusp of retirement, needed to roll over some CDs. A salesperson had pitched her on a structured product that was linked to the volatility of the S&P 500 as an alternative to a CD. The product was yielding well above prevailing rates for traditional CDs. It was obvious to me that this was a bond combined with a derivative instrument and I was dismayed that a major financial institution would pitch a near-retiree who had no understanding of derivatives on a derivative-linked product.
There are many of these products that have been created and sold. The Apple structured notes will not be the last. The companies that create these products (including, for example, Goldman Sachs) have the expertise to ensure that they are unlikely to lose money on the deal. The buyers—retail investors—are at a major disadvantage in terms of being able to assess the offerings. Zweig’s article quotes a FINRA spokesman who describes this type of product as a reverse convertible bond. The average retail investor will have no idea what this means and that is the problem.
The overall punch line of this story is that you should not buy financial products that sound too good to be true or that you don’t understand. For the vast majority of investors, many structured products have both of these worrisome features.
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