A structured product or note is an investment vehicle that promises to pay a certain yield over a period of time. Like a certificate of deposit, it has a maturity date and a specified rate of return and is usually underwritten by a bank. Importantly, unlike a CD, there is no government guarantee involved, and you may never get your money back.
In recent years, structured products have come in all shapes in sizes and are called everything from "principal protected" to "reverse convertibles." Banks and Wall Street brokers sold more than $50 billion of them last year. Often, they are no more than masked loans that investors make to banks. They are generally linked to derivatives, vehicles that bet that an underlying investment such as a stock, bond, or index will rise or fall.
Since thousands of these products have been pitched with principal protection guarantees, they appear to be secure. Yet the underlying valuation of the derivatives is not transparent, and you could lose money. Banks and brokers love them because they can sell them to income-oriented investors starved for yield. It also doesn't hurt--at least to those selling them--that they carry high commissions and fees.
I've been studying structured products for the past year (my research was funded by a grant from the nonprofit Nation Institute), and I've found myriad problems with them. In fact, I've discovered that investors have lost more than $160 billion in structured and complex income investments.
Why haven't you heard more about structured products? Because they are loosely regulated. Not even the new financial reform law reined them in. Here are some specific problems:
- No regulator vets them before they hit the market, and they continue to be hugely profitable for banks and brokers.
- Morningstar can't track them because pricing is not posted daily, each one is slightly different, and they are more opaque than a black box.
- It's very difficult to get inside of one to see how they work and how much they will cost you once underwriting fees, commissions, and other embedded costs are subtracted from your principal.
- Their acronym-rich, mind-numbing prospectuses spell out some risks, but do little to clearly explain costs or the real downside of these complex vehicles. Many brokers themselves don't fully understand how they work.
- The worst part about structured products is that you lock up your money for years in hopes of getting a better return--up to 30% in some cases. Yet they are actually wagers that limit your upside and downside, so no one really knows what will happen until you reach your maturity date. You'd be much better off in low-cost exchange-traded funds or hedging a position with options contracts--provided you understand them or work with a registered investment advisor who is a fiduciary.
What's certain about a structured product is that it is really an unsecured loan to a bank; you will not get your principal back if the bank fails. That's what happened to investors who bought more than $1 billion in principal protected notes from UBS Investments and other brokers in 2008. The vehicles were issued by Lehman Brothers, the debt-engorged investment bank that ultimately failed in September 2008.
Failed structured products have trapped even the most sophisticated investors, so don't feel bad if you don't know their perils. Thomas Motamed and his wife, Christine, were awarded $2.2 million
in a recent arbitration settlement with UBS. Motamed is the CEO of CNA Financial Services. The Motameds' action is part of a wave of investors who are trying to get their money back for everything from the bum Lehman notes to bond funds that contained structured mortgage derivatives.
If you do choose to consider a structured vehicle--I certainly don't recommend them--have them vetted by a certified financial planner (who doesn't sell them), a registered investment advisor (RIA), or a chartered financial analyst. An RIA who doesn't work on commission can decipher pricing and customize them to your portfolio.
If you've already lost money in a structured product, consider consulting a lawyer who specializes in investor arbitrations (see www.piaba.org
By all means, if you are pitched one of these vehicles, get them reviewed by an independent third party before you lock up your money. They are to be completely avoided unless you understand them thoroughly and understand how much money you can lose.
Editor's Note: Since publication of this article, we received a response letter from Eric Greschner, a Senior Portfolio Manager-Managing Partner at Regatta Research & Money Management, LLC and a national trainer and certification instructor with the "Structured Investments Specialists" designation at YourFinancialCoaches.com. Click here to read more.
You can read John Wasik's reply to that letter here.
John F. Wasik is a Morningstar columnist and author of 13 books, including The Cul-de-Sac Syndrome: Turning Around the Unsustainable American Dream. The views expressed in this article do not necessarily reflect the views of Morningstar.com.