CoCo's are NoNo's

One would have thought that the main lesson of the Credit Crunch and Financial/Economic Crisis is the danger that can be created by newfangled and little-understood financial 'innovations'. The need for banks to raise additional capital has led to the design of 'Contingent Convertible Bonds' (CoCo's for short). These bonds lure investors with relatively high nominal interest rates that make them appear attractive to those who are desperate to get some positive return on their investments. Even so-called sophisticated investors in large financial institutions get tempted. Partially because they do not play with their own money or they will long have moved on to other jobs or positions when the proverbial s*** hits the fan. They may also not be as sophisticated as their clients (pensioners, mutual fund savers and private clients) assume. It will be interesting to see how regulators treat these securities if they become more of a mainstream investment option. They will have to decide whether their role is to protect the banking establishment or the investors. We know on which side they should be and we are definitely siding with the investors on this issue. Dangerous bets such as CoCo bonds should not be in any investor's toolkit but should be strictly reserved for regular visitors to casinos and betting shops. Not for nothing the link above talks of a ticking time-bomb with respect to these securities.

Derivatives, the Devil and the Holy Water

Most private - even if sophisticated - investors will have never heard of Warren Buffett's famous dictum where he described derivatives as 'financial weapons of mass destruction'. We always have advised readers and clients to give derivatives (including 'structured' or 'guaranteed' products) a wide berth. Most investors - including Yours Truly, do not have the capability to look behind the complicated financial mathematics that is required to properly understand these concoctions. Neither do we have the slightest desire as it would be a futile exercise. If properly priced these instruments basically are a chip to participate in a financial bet that is a zero sum game. And half the participants are by definition destined to loose. We leave it up to the imagination of the reader to guess on which side a part-time investor will find himself when he pits his wits against highly motivated (because highly paid) financial engineers who do nothing else but design 'products' that allow them to profit from the losses of the other party to the bet. A particularly drastic illustration is provided by the latest revelation of the popular game played by blue chip (and lesser) financial institutions called heads I win, tails you loose. Does a storied bank with a reputation to loose really need to sell a 'variable prepaid forward' to an unsophisticated lady? The lesson is clear: ordinary private investors should stay clear of derivatives like the devil from the holy water!

Why is your Financial Adviser offering 'Alternatives'?

When being offered any financial product investors should always make sure that they really understand them and are not swayed by the sales pitch they get from a financial adviser. While the inherent risks in any product should be the main consideration there is also a need to have a good look at any fees associated with the product.

Use fee-based adviser and liquid products

Recommends William Baldwin (Forbes).

What are 'complex financial products'?

An arbitration award that related to the sale of a 'complex financial product' illustrates the problem that ordinary investors face when offered these products. In nearly all such situations they find themselves at a severe disadvantage vis-a-vis the salesperson or financial adviser. It is like asking the patient to make a judgement about the correct procedure when faced with cancer. So trust is of paramount importance in any relationship between an investor and financial professionals. Sadly, we can only recommend to always get a second opinion from a neutral expert before buying any financial instrument as the layman cannot really know when an investment vehicle is 'complex' enough to warrant special caution and analysis.

Danger of Structured Products - a Case Study

Two investors were recently awarded a multi-million arbitration award by a US court. The case illustrates the danger of putting too much trust in portfolio advisers. Investors should be particulary vigilant when presented with complicated, especially 'structured' investment products. The rule should be: what you cannot explain to your wife or grandmother in a few simple sentencies should not even be touched with the proverbial barge-pole. How many ordinary people - even those working in challenging professional jobs - do really understand municipal arbitrage strategies sold to the investors under the cryptic name ASTA/MAT? Investment Advisers offering such products are nothing else than salesman lured by the fast fees that are usually part of such 'products' and should be treated with a healthy amount of suspicion.

Thinking of buying 'Structured Products'?

If you are thinking of buying a so-called 'structured' investment product you could do worse than having a look at this court judgement. It deals with the case of a rich individual and his experience with 'barrier' notes or 'reverse' convertible notes that he bought from one of the major providers of private banking services. Readers should remember that there is no free lunch in the investment world. If they are not able to dissect the intricate mathematics behind the construction of such investment vehicles they are at a disadvantage vis-a-vis the providers and their salesmen. Even the experts often disagree about the correct valuation of the options that are packaged deep inside and as a consequence a lay investor stands no chance to value such securities correctly or - even more importantly - assess the inherent risk that he is asked to assume.

Growthbuilder - but is it building your wealth?

A new structured product has just been launched in the UK and it carries the promising name 'Growthbuilder'. But before you rush to sign on the dotted line potential investors should ask themselves if they understand the complicated option strategies that are packaged into this product. Only then they could be assured that they buy the product at a fair price and are not charged excessive mark-ups by the vendor. And even if they - or their unbiased advisor (who has no financial interest in the sale of the structure) - can understand the sophisticated mathematical models it does not mean that an investment should be made. All option strategies suffer from the defect that investors have to be extremely accurate in their timing - in addition to the already difficult task of choosing the right investment in the first place. The Libyan Investment Authority found that out to its not inconsiderable cost (which in its case surpassed the billion dollar mark quite comfortably). Dealing with sophisticated investment professionals that are incentivised by commission payments should only be undertaken with extreme care and 'Buyer beware' should be foremost on any investor's mind.

Libyan Investment Authority - How not to structure a portfolio

This revealing snapshot demonstrates that all investors - however (un)sophisticated they may be - should pay more attention to the importance of designing a portfolio that is consistent and not just a random collection of holdings that are the result of uncoordinated input received from news or financial product salespeople. Any investor employing more than one money manager has the problem that he may harbour holdings that are in essence based on contradictory assumptions and therefore expensive and inefficient. At the same time the Libyan holdings also underline the riskiness of 'structured investments' that are at best only understood by those who sell them (and sometimes not even by these mathematical wizards themselves). Anyone without a PhD in Mathematics would do well to give these 'structures' a wide berth.

Today's War: Savers versus Speculators

When the manager of the world's largest bond fund says that people are facing 'financial repression' it highlights the battle between the ordinary citizen-savers and the speculators who caused a near-collapse of the financial system and the ensuing artificial depression of real interest rates. Despite this deplorable consequence of poor financial regulation investors should not be tempted into risky investments in order to make up for the low interest rates they receive at the moment. While a return of 1 percent a year may be hurting in the pocket it is nothing compared to a much larger loss in ill-conceived gamble in speculative shares or 'investment products' marketed by aggressive salesmen that are only out to cash in on fat sales commissions. It would take years to make of for a loss of only 10 percent of principal and the risk for much higher losses cannot be excluded.

Investment Fund Performance - More than meets the Eye

If you thought that the problem of selecting the right investment fund from among the thousands on offer should not be all that difficult you may well have a look at this article. The investment management industry may find it profitable to segment its product offerings into more and more specialised offerings but that makes it more and more difficult for the investor to find the right fund. There are more investment funds out there than there are publicly listed shares and when one adds all the 'structured' investment products the list only gets longer.

Danger of being short volatility

I usually try to avoid investment jargon and warn clients to be suspicious when they are bombarded with exotic terms that require at the very minimum an advanced degree in mathematics in order to be understood. I use the term 'being short volatility' in order to send a wake-up call to readers. In the ordinary course of investment it is recommended not to write naked options as the investor is exposed to an open-ended risk. Sometimes these option exposures are cleverly packaged (hidden?) in complicated structures that look perfectly innocent to the naked eye.

Leave Derivative Esoterics to the Specialists

An article in a Swiss financial newspaper that is also widely read by more or less sophisticated private investors recently carried an article explaining how to use the 'Barrier Hit Probability' when evaluating a certain type of structured derivative product (often known as Warrant or 'Certificate'). We advise all but the most enterprising investors not only to not burden themselves with the details of such products but to stay away from any investment in them (or advisers that try to put their money into such products). Not even the experts agree on how to value these products and the underlying assumptions are so difficult to predict that the results are only giving a false sense of security.

Swaps pose new risk for your investment funds

Just when Private Investors would have hoped that a new, more rigorous regulatory regime would protect their assets from careless oversight - or outright fraud - the growing use of swaps by investment managers poses a new risk for the safety of investments. Most Private Investors - and many investment professionals and finance managers - have only the haziest of notions when it comes to the intricacies of swaps (and many other derivatives or 'structured' products) and therefore investors are well advised to obtain help when selecting suitable investment products.

Do you know how a 'Mezzanine Certificate' functions?

We have to admit that even after 40 years working in the financial markets or with financial instruments we have only the haziest notion of how such an investment instrument is structured. So it is no wonder that a major financial institution is being sued by German investors who have been sold such a product. As always we advise investors to be vigilant and not buy investment products that they do not fully understand.

Alphabet soup with 'certificates'

If anyone wants proof that the proliferation of investment 'certificates', warrants and other structured products has gone too far he only needs to look that Deutsche Bank's website for its x-markets products. I would hazard a guess and estimate that not even 5 per cent of all market professionals in stock exchange departments or investment management firms would be able to understand ALL listed products. Does anyone other than those involved in the manufacturing of these investment vehicles really master all the intricacies of their behaviour? We advise investors to be on the lookout and be vigilant in case their financial advisers try to put such structured investment products into their portfolios.

Are Structured Products Suitable for Retail Investors?

Those who understand advanced financial market concepts may read the whole paper but for the rest of our readers we provide the conclusion:

Equity-linked notes are complex, opaque and expensive - and the more complex and opaque they are, the more expensive they are. Even with the best disclosure materials and the most thoroughly trained and supervised registered representatives, it is unlikely that retail investors can understand the risk-return tradeoff and the costs being incurred in some of the complex equity-linked notes and structured products currently being marketed. (Are Structured Products Suitable for Retail Investors? by Craig McCann and Dengpan Luo, Securities Litigation and Consulting Group, 2006)

Lunatics running the asylum?

This expression comes to mind when reading the judgement concerning the repackaging of a repackaging of notes that represented an interest in an investment fund. Anyone who thinks that the activities described in the judgement represent more than a pass-the-parcel round trip designed to harvest fees at every stop at the expense of (which?) real investors may well be the right candidate to be sold in-transparent investment products in the future. Anyone who scratches his head and asks: 'What does all this have to do with sound long-term investment?' is well advised to be wary of overcomplicated investment vehicles and scrutinise the costs and risks associated with his investments very carefully.

Callable Snowball Floater - another confusing investment

The structured investment product world is full of technical terms that make even the heads of many a seasoned investment pro spin. But how many individual investors - sophisticated or not - really understand all the terms of the structure when they sign on the dotted line before parting with their hard-earned money? And if the investment is made on their behalf by investment managers - do these professionals understand them? We would bet that 99 percent of those putting money into structured investment products did not read the full prospectus - and even if they did they probably would not be much the wiser as it needs a mathematical PhD to look behind the scene and understand the risk-reward ratio and underlying fees. What is even more dangerous is when these products are given a tempting and innocuous sounding name such 'Guaranteed Investment'. As we have recently seen, nothing is guaranteed in the investment world, even the obligations of governments are subject to modification as demonstrated in countries such as Argentina. And who would put all his money into Greek government bonds now?