Structured products and ‘guaranteed’ equity bonds were never a good idea

A financial story gathering steam is the alleged miss-selling of structured investment products that ‘guaranteed’ your capital was safe.

The issue concerns products ultimately backed by Lehman Brothers, the failed U.S. investment bank.

Since what is left of Lehamn Brothers may be unable to honor its commitments as the underwriter of certain elements of the products, investors’ supposedly 100% secure capital is at risk.

The BBC’s Working Lunch program has been on the case:

On page four, under the heading “Full repayment of your capital at maturity”, you are reminded that the plan is “100% capital secure” and that you are investing in something with “growth potential without risking your capital”.

What you wouldn’t expect after reading all of the above is to be informed that all your money may have been lost due to the collapse of the US investment bank, Lehman Brothers, just weeks later in September 2008.

You didn’t even know Lehman was involved.

Investors’ capital is always at risk with every investment, but the word ‘guaranteed’ has a hypnotic affect on people.

In reality no investment product is ever guaranteed. It’s always about risk versus return.

I do have some sympathy for both the investors and the advisers in this case:

• Investors were deliberately seeking out a secure product, and could not have predicted the collapse of Lehman Brothers.

• Financial advisers were equally poorly placed to guess that Lehman Brothers would go bust.

The courts will probably spend years deciding who is right and wrong.

But regardless, these structured products were always horrible investments.

Why I don’t trust these ‘guaranteed’ structured products

I’ve never liked structured products, even before the latest Lehman-related issues.

Called names like ‘Guaranteed Equity Bonds’, they typically tell investors that their capital is either completely safe or at least heavily protected, and usually offer either a fixed annual return or some percentage of the growth of a particular index over some time.

The capital protection and return is usually linked to certain hurdles.

You may get all of your capital back if the index stays above level ‘X’, for example, but lose 1% for every 2% decline below that level.

More esoteric plans have been linked to things like banks not plunging in value (oops!) and house prices (double oops!)

Confusing? Certainly! Even worse, despite labeling them bonds to make them sound safe (or sometimes ‘plans’ to make them sound purposeful) the underlying investments are actually derivatives, such as option calls on the value of a particular index on some specific date.

If the average purchaser knew they were buying derivatives – a class described by Warren Buffett as ‘financial weapons of mass destruction’ – they might not have been so keen to invest.

I steer clear of structured products because:

• They usually don’t pay company dividend income, but rather an income linked to growth in the index’s value – much less reliable and more volatile than dividend income.

• They are hard to evaluate – even the best analyst couldn’t tell you what level an index will be at in five years’ time.

• A mix of cash savings and a dividend paying index fund can offer similar attributes more cheaply and straightforwardly.

• They are opaque – investors don’t really see what they’re buying, or at best it’s heavily disguised in the small print.

• They are inflexible, locking your money away for several years on pain of various penalties.

• They confuse instead of educate, encouraging people to believe in silly things like ‘guaranteed’ investments and the tooth fairy.

• Their robustness depends on the health of various parties that the investor may not even know are involved (such as in the Lehman Brothers case).

All this complication tells you two things: investors in structured products are trying to avoid the realities of investing, and financial service providers want to make money from that investor fear.

Nobody expected Lehamn Brothers to go bust

Having explained why I steer clear of structured products, I will elaborate on why I feel some sympathy in the case of those hurt by the collapse of Lehman Brothers.

I actually heard a financial commentator on the radio saying:

It was down to individuals to investigate who was underwriting these products, and to make a decision accordingly.

What absolute rot! It is sloppy hindsight of the highest order to say anyone could have foreseen a couple of years ago that mighty Lehman Brothers would go bust.

The truth is investors who did look further into the small print to find Lehman Brothers’ name would have been reassured.

I’m sure I’ll get responses from other blogs saying they knew Lehman Brothers would go bust all along due to over-leveraging.

Yeah yeah, I bet.

It’s true a few traders realized sub-prime housing would end in tears, but even they shorted mortgage-backed securities, not the investment banks themselves, in anticipating the resultant credit crisis.

And even if a few savvy investors did anticipate the end of Lehman Brothers (and Merrill Lynch, and the threat to Goldman and the other investment banks) they were hardly the same everyday investors being sold guarantees from equity ‘bonds’.

Suggesting the average person should not have invested when they saw the name Lehman Brothers is a red herring. Investors should instead be taught that there is no such thing as a guarantee, and that every investment can fail.