Navigating Structured Products

by Brian Harris, Senior Editor, Dimensional Fund Advisors

In recent years, structured products have gained favor among retail investors in Europe and the US. Investment banks promote these securities as sophisticated tools to help investors manage downside risk, enhance returns, or achieve other investment objectives.

Sales have grown briskly since 2006, and despite a decline after the 2008 market crisis, some industry sources expect a rebound in sales and a flurry of new products in the future.1 With this in mind, it may be useful to understand how the products work and to evaluate the costs, benefits, and tradeoffs before considering one in your investment strategy.

Basic design of structured products

A structured product is a contract that promises to pay a future amount based on the performance of an underlying asset, such as a stock, market index, or commodity. The payoff is typically linked to a preset formula. Most structured products are designed to either preserve capital or enhance returns, and are typically issued as notes.2 The notes offer a specific payout over a designated period or at maturity, and the final payout depends on the performance of the underlying asset as well as the value of the derivatives written on it. Since the product typically is issued by an investment bank, the investor is exposed to the credit risk of that entity.

One common product, a principal-protected note, generally offers a minimum return equal to the original investment, plus a potential return tied to performance of an underlying asset, such as a stock market index. If the index drops during the term, the investor gets his money back, but if the index rises, he may receive the upside gain, but usually only a part of the underlying asset’s gain. Structured products can be replicated by portfolios composed of an interest-bearing instrument, such as a certificate of deposit or zero-coupon bond, equity securities, and options or other derivative securities whose performance is linked to the underlying index.3

The following summarizes a few common characteristics of structured products:

•    Complex design: Most products have a complex design, which can make analysis of pricing, risk exposure, and potential outcomes more difficult. Some investors equate this complexity with higher potential returns, when, in fact, it may only mask high fees and risk. Worse yet, investors may not understand the range of possible outcomes. During the 2008 market crisis, some investors learned a hard lesson when the issuing firm went bankrupt or when their structured product experienced losses from poor performance of the underlying asset.

•    Substantial cost: These products tend to carry a significant markup and costs that in some cases are difficult to quantify, especially if an investor lacks the technical knowledge to analyze the underlying components of the strategy.

•    Replication: The payoff of virtually any structured product can be replicated in a portfolio by holding the underlying securities, then buying or selling derivatives written on those securities. In many cases, the costs associated with the replication portfolio are much lower than the structured product itself.

•  Tradeoffs: In return for receiving a prescribed payout, investors must accept a tradeoff in the form of a lower return and/or limited upside potential. When evaluating a structured payout, remember that there is no free lunch in the risk-return tradeoff. To pursue higher expected returns, you must accept more risk. If you do not want to bear the risk, you must transfer it to other investors and pay them for taking it.

•    Multiple Risks: First, there are the inherent risks of the underlying security (e.g., the stock or index). Investors also are exposed to credit risk of the issuing firm. The contract is an agreement with the issuer to make a pre-determined payment in the future, and thus, it is contingent on the firm being able to deliver. Liquidity risk is another issue. Although many structured products are listed and traded on exchanges, they may be difficult to sell, especially in a volatile market. To avoid a potential liquidity problem, investors should consider the time horizon of the product and attempt to match its maturity to their anticipated financial need or objective.

• Tax considerations: It is also important to check tax consequences. Some instruments may have certain appeal under the current tax rule. But, often, tax consequences differ according to the investment situation (e.g., whether one buys at the issuance or in the secondary market).

Who might benefit?
A structured product might help an investor who needs a specific payout at a designated point in the future and who is willing to pay another party to shoulder much of the uncertainty. But this benefit generally comes at the expense of lower yield or limited upside potential.

One example may be an individual who currently holds restricted company stock whose value may account for a significant portion of his total wealth. Although he might prefer to diversify this exposure, company rules may prohibit a sale until some future date. A structured product might provide protection against the downside risk of the company’s stock (even though this might mean giving up the upside potential of the stock), and at the same time, provide better-diversified exposure to an equity index, such as the S&P 500.

Perhaps most important, investors who are considering a structured product should consider why they even need a highly structured payoff in the future—and if so, whether the payoff can be structured by other means in the portfolio. In many cases, the strategy can be replicated at a lower cost, and perhaps with less risk. Many investors would prefer an alternative that is less complex and more transparent. And as the recent credit crisis taught many investors, it is wise to avoid investing in things you do not understand.

Endnotes

1 Larry Light, “Twice Shy on Structured Products?” Wall Street Journal, May 28, 2009.

2 A reverse convertible bond is one example of a yield enhancement tool. It pays investors a higher coupon rate than other comparable bonds due to its higher risk. This risk comes in the form of the issuer having the option to pay off the debt with either cash or a predetermined number of common stock shares. The method of payment at time of maturity will depend on the stock price, and the issuer will pay with common stock when it is advantageous to do so. The reverse convertible bond was popular until the last market crisis, when many investors experienced heavy losses when they were paid off with lower-value stock shares.

3 A call option provides the holder the right to buy the underlying security at a given price at a certain time in the future. A put option provides the holder with rights to sell the underlying security at a pre-specified price on maturity date. (American-style options can be exercised before the maturity date, whereas European-style options can be exercised only on the maturity date.) An option holder will exercise the put or call option only if the payoff is positive.

Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. This material on structured products is provided for informational and educational purposes only and should not be considered investment advice or an offer to buy or sell securities.

The following article from Investor’s News is an eye opener. It is so easy to think investing is easy – think again. And, enjoy reading this article and take heed.

Like so many investors in the spring of 2009, Gordon Wolf needed to dig out of a hole.

A 68-year-old psychologist in Napa, California, Wolf was a buy-and-hold sort of guy, yet the nest egg he had entrusted to his broker at Merrill Lynch was suddenly down by more than 50 percent.

The broker had invested much of it in a range of exchange- traded funds, or ETFs, a relatively new financial innovation that was replacing mutual funds in the hearts and portfolios of many investors. An ETF, which can be bought or sold like a stock, attempts to track the price of a particular basket of assets–tech stocks, for instance, or high-yield bonds, or commodities ranging from wheat to gold to oil to natural gas.

The commodity ETFs were supposed to offer a hedge against equity losses, but in the crash of 2008 everything fell in tandem. Now it was early 2009, and Wolf was watching oil fall to $34 a barrel. That had to be an opportunity, he figured, so he called his Merrill broker and asked about the U.S. Oil Fund, an ETF designed to track the price of light, sweet crude. “This seems to be something good,” Wolf told the broker, and had him buy about $10,000 of USO.

What happened next didn’t make sense. Wolf watched oil go up as predicted, yet USO kept going down. In February 2009, for example, crude rose 7.4 percent while USO fell 7.4 percent. What was going on?

For the rest of this article, go to Investors in commodity ETFs getting “eaten alive”

Recent Market Volatility in Perspective

The US stock market has taken investors on a bumpy ride in recent years. This volatility has tested investor discipline and prompted some people to question their commitment to equities. While no one knows the future, looking at the past may help you gain a better view of long-term market performance and put the recent market volatility in perspective.

The above chart shows the historical distribution of US market returns since 1926. The performance years are stacked in ascending order by return range. This chart illustrates that:

•    Market performance over the past two years has been extreme by historical standards. In 2008, US stocks experienced their second-worst calendar return in eighty-four years. Then, in 2009, stocks rebounded strongly to deliver a return in the top quartile of the historical distribution.

•    Over the long term, the market’s positive return years have outnumbered the negative return years. Since 1926, the market has experienced a positive return in almost three-quarters of the calendar years.

•    Not only are the positive years more numerous, the chart shows a larger concentration of performance in the higher ranges of returns.

•    The sequence of calendar returns appears random, suggesting that accurately predicting future performance is a difficult task for any investor or professional manager.

Over time, the market has rewarded investors who can bear the risk of stocks and stay committed through various periods of performance.

This data was provided by Dimensional Fund Advisors.

Rebalancing Act

In a given period, asset classes experience divergent performance. This is inevitable and, in fact, desirable. A portfolio that holds assets that do not perform similarly (i.e., with low return correlation) will experience less overall volatility. That results in a smoother ride over time. However, dissimilar performance also changes the integrity of your asset mix, or allocation—a condition known as “asset drift.” As some assets appreciate in value and others lose value, your portfolio’s allocation changes, which affects its risk and return qualities. If you let the allocation drift far enough away from your original target, you end up with a different portfolio.

Once you form a portfolio to match your current investment goals and risk tolerance, you should preserve its structural integrity since asset allocation accounts for most of a portfolio’s return.¹ This is a strategic priority, like portfolio design or investment manager selection. To efficiently pursue investment goals, you must manage asset drift.

Rebalancing is the remedy. To rebalance, you sell assets that have risen in value and buy more assets that have dropped in value. The purpose of rebalancing is to move a portfolio back to its original target allocation. This restores strategic structure in the portfolio and puts you back on track to pursue long-term goals.

Why rebalance?

At first glance, rebalancing seems counter-productive. Why sell a portion of outperforming asset groups and acquire a larger share of underperforming ones? Intuition might suggest that selling previous winners may hinder returns in the future. This logic is flawed, however, since past performance may not continue in the future—and there’s no reliable way to predict future returns.

Equally important, remember that you chose your original asset allocation to reflect your risk and return preferences. Rebalancing realigns your portfolio to these priorities by using structure, not recent performance, to drive investment decisions. Periodic rebalancing also encourages dispassionate decision making—an essential quality during times of market volatility. Moreover, if and when your overall financial goals or risk tolerance change, you have a foundation for making adjustments. In the absence of a plan, adjustments are a matter of guesswork.

Challenges and decision factors

In the real world, portfolio allocations are usually complex, incorporating not only fixed income and equity, but also the multiple asset groups within equity investing. The more complex a portfolio’s allocation, the greater is the need for maintenance.

Determining when and how to effectively rebalance requires careful monitoring of performance and awareness of your tax status, cash flow, financial goals, and risk tolerance. Rebalancing also incurs transaction fees and potential capital gains in taxable accounts. Thus, while there are good reasons to rebalance, the benefits must outweigh the costs.

Given these challenges, a practical rebalancing approach will establish asset drift triggering points while leaving enough flexibility to manage costs effectively.

Defining triggering points helps investors decide when to rebalance. Most experts recommend rebalancing when asset group weightings move outside a specified range of their target allocations. This may be widely defined according to stock-bond mix, or more appropriately, according to a percentage drift away from target weightings for categories like small cap stocks, international stocks, and the like.

While rebalancing costs are unavoidable, several strategies can help minimize the impact:

• Rebalance with new cash. Rather than selling over-weighted assets that have appreciated, use new cash to buy more under-weighted assets. This reduces transaction costs and the tax consequences of selling assets.
• Whenever possible, rebalance in the tax-deferred or tax-exempt accounts where capital gains are not realized.
• Incorporate tax management within taxable accounts, such as cost basis management, strategic loss harvesting, dividend management, gain/loss matching, and similar considerations.
• Implement an integrated portfolio strategy. Rather than maintaining rigid barriers between component asset classes and accounts, manage the portfolio as a whole.

Rebalancing incurs real costs that can detract from returns. We can help investors define ranges within which investment components can acceptably drift, and adopt cost-saving strategies during rebalancing, paying particular attention to tax-sensitive transactions. In helping our clients rebalance, we strive to develop a structured plan that remains flexible to each individual’s unique blend of goals, risk tolerances, cash flow, and tax status.

No one knows where the capital markets will go—and that’s the point. In an uncertain world, investors should have a well-defined, globally diversified strategy and manage their portfolio to implement it over time. Rebalancing is a crucial tool in this effort.

Endnotes

¹ Gilbert L. Beebower , Gary P. Brinson, and L. Randolph Hood, “Determinants of Portfolio Performance ,” Financial Analysts Journal 42, no. 4 (July/August 1986): 15-29. Gilbert L. Beebower, Gary P. Brinson, and Brian D. Singer, “Determinants of Portfolio Performance II: An Update,” Financial Analysts Journal 47, no. 3 (May/June 1991): 40.

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party.

Disclosures

Although investors may form their expectations from the past, there is no assurance that future investment results will model historical performance.

Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.

Stocks offer a higher potential return as compensation for bearing higher risk. However, this premium is not a certainty, and investors should not expect to consistently receive higher returns from stocks. In fact, market history shows extended periods when stocks did not outperform bonds.

Diversification neither assures a profit nor guarantees against loss in a declining market.

A bond portfolio designed for income also carries significant risks, including default and term risk, call risk, and purchasing power (inflation) risk. Foreign securities also are exposed to currency movements.

Great, actually. The Emerging Markets asset class is the most volatile broad asset class there is. How was the performance last year when it seemed the whole world was going down the toilet during the first quarter? Here are the returns for four discreet Emerging Markets mutual funds from Dimensional Fund Advisors:

Fund Name                                            Symbol         2009 Total Return
DFA Emerging Markets Core              DFCEX                    83.58%
DFA Emerging Markets Small Cap     DEMSX                   99.74%
DFA Emerging Markets Value            DFEVX                    92.28%
DFA Emerging Markets Portfolio       DFEMX                    71.77%

Were these highly concentrated portfolios with great stock picking? No. These are all very broadly diversified passively-managed asset-class funds. The chart below shows approximately how many stocks were in each of these funds during 2009. The interesting fact here is that the most concentrated (which cannot, under anyone’s analysis be considered a concentrated portfolio) was the poorest performer – if you can call a one year return of 71.77% poor.

Fund Symbol         Approx. Number of Stocks
DFCEX                                         2719
DEMSX                                        2100
DFEVX                                         1924
DFEMX                                          640

Sure, these guys had downside movement during 2008 commensurate with the upside in 2009. This indicates in stark relief the value of sticking with your asset allocation model and then rebalancing the portfolio. Those who did so over the past couple of years are back to being whole again or close to it.

So what is the take away here? Volatile asset classes, purchased broadly and managed passively, and rebalanced appropriately will enhance the risk adjusted returns of an investment portfolio and put more money in an investor’s pocket over time. It requires discipline during excruciatingly painful market moves, and it pays off.
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Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and charges and expenses of the Dimensional funds carefully before investing. For this and other information about the Dimensional funds, please read the prospectus carefully before investing. Prospectuses are available by calling Dimensional Fund Advisors collect at (310) 395-8005; on the internet at www.dimensional.com; or, by mail, DFA Securities LLC, c/o Dimensional Fund Advisors, 1299 Ocean Avenue, Santa Monica, CA 90401. Mutual funds distributed by DFA Securities LLC.

In the past five years, actively managed stock and bond funds have shown a significant rate of non-survival, and among the survivors, only a few have consistently outperformed their category benchmark.

Some people claim that strong financial markets offer opportunities for active managers to add value, while others say that active management works best in market downturns. During the past five years, the US stock market has experienced several years of moderate gains and one year of extreme underperformance (2008).

So, how have active mutual fund managers performed during this period?

As shown in this graph, of the 3,662 actively managed US equity funds operating at the beginning of 2004, 28.5% of the universe (1,043 funds) disappeared during the five-year period through 2008. Most of this non-survival occurred in years when the market delivered positive returns.

Some investors might conclude that a 71% survival rate offered strong odds of choosing a successful fund over the period, with a fund’s success defined as beating the performance benchmark for its fund category. But survival rate alone does not offer insight into future performance of a fund, as demonstrated in the next slide.

Although 2,619 actively managed US equity funds (71%) survived the five-year period, most funds did not outperform their category benchmark.

This graph shows the percentage of funds in the surviving universe that beat their benchmark in consecutive years. In the first year (2004), 33.2% of the funds were winners, but by year five (2008), only 1.4% of the funds (38 out of 2,619 survivors) had consistently outperformed their benchmark.

Additional statistics from the study reveal the inconsistency of active fund performance. On average, only 41.7% of the surviving funds beat their benchmark each year, and only 39.7% of the survivors delivered a five-year total return above their respective fund category benchmarks.

Despite the strong evidence against active strategies, some people may believe that as a group, active managers can add value. The challenge comes in identifying winning managers in advance. Some investors attempt this by choosing managers with strong past performance.

Evidence does not support their approach. In the five-year period under study, recent winners did not reliably repeat their outperformance. In fact, less than half (46%) of the funds that beat their benchmark in the preceding year did so again in the following year. Among the funds that outperformed in 2004 and 2005, only 5% beat their benchmark over the entire five years.

Like active managers in the equity universe, bond fund managers have a significant rate of non-survival and underperformance.

As shown in this graph, of the 1,670 actively managed bond funds operating at the beginning of 2004, about 27% of the universe (458 funds) disappeared during the five-year period through 2008.

Some investors might assume that a 73% survival rate offered reasonable odds for choosing a winning fund over the period, with a fund’s success defined as beating the performance benchmark for its fund category. However, survival rate alone does not offer insight into a fund’s future return.

Fund survival does not imply success. Although 1,213 actively managed funds (73%) survived the 2004-2008 period, most did not outperform their fund category benchmark.

This graph shows the percentage of bond funds in the surviving universe that beat their benchmark in consecutive years. In 2004, over 41% of the funds outperformed their respective category benchmark. By year five (2008), however, only 0.5% of the funds (7 out of the initial 1,670) had outperformed in all five years.

The study also reveals that, on average, only 30.1% of the surviving funds beat the benchmark in a given year, and over the five-year period, only 12% of surviving funds (146 out of 1,213) delivered a total return above their benchmark for the entire period.

Despite the strong evidence against actively managed bond funds, some investors believe that active managers as a group offer the best opportunity for long-term success, assuming these managers can be identified in advance. One approach is to buy recent winners in hopes that their outperformance will continue in the future.

But past winners did not typically repeat over multiple years. In this five-year period, on average, only 42% of the funds that beat their category benchmark in the preceding year outperformed in the following year, and of the funds that outperformed in 2004 and 2005, less than 2% (7 out of 399) beat their benchmark over the entire five years.

To view this video presentation go to Behavioral Biases

Let’s begin with some factual data and the word of some recognized authoritative experts.

First, Standard & Poors: “Over the five year market cycle from 2004 to 2008, S&P 500 outperformed 71.9% of actively managed large cap funds, S&P MidCap 400 outperformed 79.1% of mid cap funds and S&P SmallCap 600 outperformed 85.5% of small cap funds. These results are similar to that of the previous five year cycle from 1999 to 2003.”[1]

“After taking risk into account, do more managers than you’d see by chance outperform with persistence? Virtually every economist who studied this question answers with a resounding ‘no.’ Mike Jensen in the sixties and Mark Carhart in the nineties both conducted exhaustive studies of professional investors. They each conclude that in general a manager’s fee, and not his skill, plays the biggest role in performance.”

Eugene Fama, Jr.

“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.”

William Bernstein, The Intelligent Asset Allocator

“It turns out for all practical purposes there is no such thing as stock picking skill. It’s human nature to find patterns where there are none and to find skill where luck is a more likely explanation [particularly if you’re the lucky mutual fund manager]. Mutual fund manager performance does not persist and the return of stock picking is zero. We are looking at the proverbial bunch of chimpanzees throwing darts at the stock page. Their ‘success’ or ‘failure’ is a purely random affair.”

William Bernstein, The Intelligent Asset Allocator

“When some individual made a fortune in the stock market, we have a tendency to assume that was because he knew something, and of course the individual is happy to reinforce that belief – yes, I was a genius or I was very clever or I always said Microsoft was going to make me rich. But what you don’t see are the thousands, hundreds of thousands, perhaps millions of people who are going, ‘I always said that ABC Company was going to make me rich, and ABC Company went bust.’”

Professor Zvi Bodie, Boston University

“…skepticism about past returns is crucial. The truth is, as much as you may wish you could know which funds will be hot, you can’t – and neither can the legions of advisers and publications that claim they can. That’s why building a portfolio around index funds isn’t really settling for average.  It’s just refusing to believe in magic.”

Bethany McLean, Fortune

“Economic evidence shows that, from a typical investment perspective, the major capital markets of this country are highly efficient, in the sense that available information is rapidly digested and reflected in the market prices of securities. As a result, fiduciaries and other investors are confronted with potent evidence that the application of expertise, investigation, and diligence in efforts to “beat the market” in these publicly traded securities ordinarily promises little or no payoff, or even a negative payoff after taking account of research and transaction costs. Empirical research supporting the theory of efficient markets reveals that in such markets skilled professionals have rarely been able to identify under-priced securities (that is, to outguess the market with respect to future return) with any regularity. In fact, evidence shows that there is little correlation between fund managers’ earlier successes and their ability to produce above-market returns in subsequent periods.”

Restatement of Trusts [Third] §227 General Note on Comments e through h:
Introduction to Portfolio Theory and Other Investment Concepts

From current data, from academics, from journalists and from legal scholars, it is concluded that money managers cannot, with consistency, outperform the market. In another article we will discuss what one should do about this stubborn fact.

Click here to view the interview of Fama on Market Efficiency in a Volatile Market

Now that it appears that markets have reached a turning point, practitioners of the ‘dark art’ of predicting and exploiting investment trends by analyzing charts have been getting some favorable reviews.

These Technical Analysts, like the ones heard weekly on the business TV shows, use a bewildering range of tools and concepts to prophesy prices — from simple support and resistance points to daily volumes, moving averages, trend lines, oscillators and volatility.

Their esoteric approach to forecasting contrasts with that of fundamental analysis, that focuses on factors like company earnings, management, strategy, industry backdrop and the general economic environment.

One recent article in The Times of London heaped praise on technical analysts, saying they had done a much better job than fundamental analysts in charting the course of markets through the financial crisis.

Specifically, what has excited observers in the media has been a break by the S&P 500 through a “neckline” of a reverse head and shoulders formation. This, according to the chartists, is a very bullish signal.

If such indicators as head and shoulders patterns really are so reliable, as The Times¹ says, why would anyone trade against them?

Secondly, not all technical analysts agree. For every chartist who points to a bullish break on a head and shoulders formation, for instance, there may be another pointing to a bearish ‘Elliott Wave’ pattern or something like it. This contradictory condition is constant and should indicate the inadequacy of technical analysis, not support for it.

Of course, there is no way of knowing which of these techniques has got it right until after the fact, which is too late for us regular folks who want to profit from our activities in the markets. But in the meantime, it can be very diverting to look at the pretty pictures they draw. This is more of what I call “investment pornography.”

Taking a less cynical view, there is an honourable intention in technical analysis in attempting to separate the fundamental noise in pricing from the underlying signal. Many of these analysts believe in “mean reversion” — the tendency for prices to revert to their long-term average levels.

Technical Analysts also rightly understand that market dynamics themselves — shifts in daily trading volumes for instance — can be important influences on prices.

But this still leaves open the question about whether such methods can reliably predict turning points. If they did (now think about this a minute) everyone would be using them.

And while changes in security prices reflect both permanent (or fundamental) and temporary (or technical) influences, it is impossible to discern, before the event, the degree to which these varying influences will affect prices. So, how can one consistently profit from this information? One cannot.

A third observation is that most technical analysis — apart from Elliott Wave theory – is concerned with relatively short-term movements in prices. To the extent that these signals are any good, they really are only relevant to day traders whose business it is to profit from noise.

Long-term investors, by contrast, will be concerned with very long-term trends in prices and will focus on consistently capturing those risks that the historical record shows carry a reliable reward. Capital Markets U.com Magazine is interested in helping these long-term investors, not speculators.

These long-term investors will also ensure that those who manage their money are cognisant of – and are able to exploit – temporary and technical factors in the market that can affect prices.

A prudent approach to investing is one that is not dependent on forecasting — either via charts or fundamentals — yet recognizes the short-term frictions in the market that can cost investors dearly.

And you don’t even have to be a tea drinker to benefit.

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¹ Anatole Kaletsky, ‘The Fortunes of the Markets are in the Charts’, The Times, July 27, 2009