Structured notes: designed to deceive; some research!

The focus of structured products on a small segment of the return distribution, while ignoring the impact of negative scenarios does likely play on investors mental framing issues.  Unfortunately, regulators (in Canada especially) have stood back from dealing with these specific issues, partly because they do not fully understand them.  It is much easier to ask that a suitability box be ticked and for the investor to take responsibility for the decision than for regulators to get involved.  Can you imagine the impasse on agreeing a point of sale of document for structured notes: how would they face up to questions such as “Just what is the risk?”, “just what is the historical return on these products?”, “what are their option and structure costs?” ?

And now for some academic support to the over pricing of structured notes:

The following is taken from a paper “The Dynamics of Overpricing in Structured Products. It is interesting not just because it brings together a lot of other research on the subject but the conclusions should be obvious to anyone who understands how risks and returns evolve. 

….research has begun to focus on the negative aspects of SPs arguing that issuers market and sell complex products with low expected returns (Henderson and Pearson, 2010) to retail investors by exploiting their behavioral biases and lack of financial literacy (Bernard et al., 2009).

Henderson and Pearson (2010) call SPs the ‘dark side of financial innovation’ because investors would be better off in the money market than buying SPARQs, the particular SP they analyze. Bernard et al. (2009) argue that issuers emphasize outcomes with high payouts and low probabilities in their marketing materials leading retail investors to overweigh those states in their expected return calculation.

Bethel and Ferrell (2007) discuss legal and policy implications of the explicit targeting of unsophisticated investors with offers of complex financial securities. In the model of Carlin (2009) issuers faced with increasing competition increase the complexity of their products to make comparisons for investors more costly and maintain overpricing.

Previous literature has consistently reported overpricing in structured products in general, for the U.S. (Bernard et al., 2009), for Germany (Wilkens et al., 2003) and for Switzerland (Grunbichler and Wohlwend, 2005), and for warrants in particular (Horst and Veld, 2008; Abad and Nieto, 2010) when compared to products on derivatives exchanges.

The extent of overpricing can be sufficiently large to ensure that expected returns lie below the risk-free rate (Henderson and Pearson, 2010) and thus there is no reason for rational investors to buy some of these products. Other studies point out how issuers take advantage of investors’ susceptability to certain mental errors like over-optimism (Bernard et al., 2009), how they optimally increase complexity to maintain overpricing (Carlin, 2009) and increase search costs (Dorn, 2010).

The following is taken from a paper, “Over pricing and Hidden Costs of Structured Products for Retail Investors: Evidence from the Danish Market for Principal Protected Notes

Our data set consists of detailed information on almost 400 Danish issues of PPNs during the period from 1998 to 2009. Comparing actual offer prices with theoretical fair values we find that on average PPNs are overpriced by about 6%. While overpricing of structured retail products is well-documented in the literature, our paper is the first to compare the level of overpricing with the product costs disclosed by sellers at issuance. We find that on average only about half of the overpricing can be explained by disclosed product costs. The finding of a significant hidden cost component in structured retail products is new to the literature.

That PPNs are overpriced relative to their fair value is not surprising  since all the different agents participating in the design, construction, marketing, and sale of these products must be compensated for their efforts.

…costs should be almost negligible after the time of issuance as no current portfolio management services are needed in connection with typical  PPNs. However, an explanation for the result can perhaps be found in the fact that PPN arrangers/issuers often point to mutual funds when critics question the costs of PPNs. Mutual fund fees and costs normally amount to around 1{2% per year, which is of course nicely comparable with our estimated average total cost of 6% for PPNs with an average time to maturity of 4 years, i.e. approximately 1.5% per year. So in the absence of better explanations for PPN costs one might conjecture that PPN arrangers simply set costs and fees of PPNs at a level that can be justified by comparisons with a well-known retail investment alternative, namely mutual funds.

PPNs with a capped option element bear higher costs and are thus more overpriced than non-capped products. Since a cap limits the upside  potential for investors and thus depresses the option value, another way of stating this result is that in general PPN investors are not properly compensated { e.g. by a higher participation rate { when  arrangers/issuers decide to cap a PPN. As suggested to us by a practitioner, one explanation for this finding may be that some PPNs are designed and priced first without taking the cap into account. The cap is then added sort of “in the last minute” as a “safety valve”, i.e. to limit the issuer’s risk from mis-estimated hedging costs


Research claims to show that market prices of most ETNs do not accurately reflect their risks and that the notes should trade at greater discounts

Structured Products In the Aftermath of Lehman Brothers

Structured Note Rules May Fail to Resolve Confusion Over Pricing

What Drives Financial Complexity? A Look into the Retail Market for Structured Products

Knowledge Asymmetry and Issuer Behavior : The Case of Retail Structured Equity Product

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