Why do investors buy structured products?

Wall Street and Stock Exchange, arrow pointing downward.

(MoneyWatch) Over the past decade, structured investment products, also known as equity- or index-linked notes, have become increasingly common in the portfolios of retail investors. And this is not just a U.S. phenomenon. In some countries, such as Germany and Switzerland, around 6 percent of all financial assets are held in structured products.

Structured products are financial derivatives whose payoff at maturity depends on one or more classical assets (mostly stocks or stock indexes). Unfortunately, they're "popular" for the same reasons many financial products are popular -- either they carry large commissions for the sellers, or they so greatly favor the issuers that they push the products on unsophisticated investors who can't fathom their complexity (but are assured by the salespeople and the advertising that these are good, safe products).

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By applying economic theory to value structured products, the authors of the paper, "Why Do Investors Buy Structured Products?" demonstrate that for rational investors the utility gains from structured products are typically much smaller than their fees. Thus, the demand for these products can only be explained by well-known behavioral factors such as loss-aversion (studies suggest that losses are psychologically twice as powerful as gains), gambling to avoid sure losses, overpaying for the small possibility of a large gain, mis-estimating probabilities, and overconfidence.

From the issuers perspective, these products are great because their complexity allows the seller to exploit the behavioral biases of investors and raise capital at well below market rates. Put another way, the products' complexity increases the likelihood of investors mis-estimating probabilities, such as the odds that a stock price will fall below a certain price.

The authors of the paper "The Dark Side of Financial Innovation" analyzed a structured product called SPARQs (Stock Participation Accreting Redemption Quarterly-pay Securities), a popular structured-equity product. They concluded that they're sufficiently overpriced that their expected returns are less than the riskless rate and that that the primary market investors pay on average an 8 percent premium for them -- the premium being defined as the difference between the offering price and an estimate of the fair value. This is an exceptionally large premium for a product that is callable after about six months and has a maximum maturity of slightly more than one year. SPARQS investors would have been better off investing in CDs.

We should address another issue -- investments shouldn't be viewed in isolation. Instead, they should be evaluated in terms of how their addition impacts the risk and return of the entire portfolio. Yet structured products are always marketed as standalone investments. And it's almost impossible to even imagine that investors buy them because their portfolios hold risks that are complimentary to the risks of the structured notes (move in the opposite direction).

In summary, the strong demand for structured investment products is probably attributable to investors' behavioral preferences and biases. Given the low sophistication of many retail investors, speculation should also be classified into this category. In other words, structured products are highly profitable for the banks that issue them, but for investors their benefits are largely illusory.

The bottom line is that the design and sale of structured products by investment banks exemplify the conflict of interest between these financial institutions and their customers. They are so destructive to investors that U.S. regulators should follow the example set by Norway and ban them.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.