Complicated Investment Products

Wednesday, June 22, 2011

I believe that by now I have accumulated some experience after 15 building business and recently finishing my PhD. However some things continue to surprise me. The recent crackdown on so called complicated products—on both sides of the Atlantic Ocean. I still have difficulties to understand what it is about?

Would you refuse laser-therapy to a patient because he or she is not able to understand the laws of quantum optics? Would you refuse someone to buy a care with an airbag because he or she is unable to understand its IC circuits? Wouldn’t that be extremely unfair?

So would it be fair to refuse to someone the best fitted investment strategy because “it is complicted”?

What would have happened to the car industry if hundred years ago a law would forbit to make “complicated cars”? What would have happened to life expectation if regulaters would crack down on complicated medical treatments? Why would anyone do that?

But in the investments industry it is something that seems to be loved by the media … or that is at least the only reasonable explanation that I can think of. Why else would regulators do so? For the sake of control? The fun of discriminating the “stupid masses”?

It gets even more surrealistic when the regulators get down to details. For example the Belgian regulator published on June 20th a press release calling for a voluntary stop on “unnecessary complicated products”. They even have the wishdom to define what is unnecssary complicated. Any investment product that does not satisfy all of the four following conditions is considered to be “unnecessary complicated”.

  1. The underlying value is sufficiently accessible — This is stangily formulated it can mean that it is liquid, available for sale for everyone (but then … why would you need an investment fund), or it could refer to the existance of a market price. In all of the three possibilities this seems absurd to me. In each of the possible interpretations I would argue that if such investment is usefull that then one exactly needs an investment fund to make it safely accessible for investorsl
  2. The investment stategy is not too complicated — This is so vague that I cannot comment. But —see further— this does not withold the FSMA to list financial institutions that will not abide by these rules.
  3. The retun is not determined by more than three mechanisms. — Again vagueness and unclarity reigns. Would an bond portfolio qualify for example? Well the return is determined by at least the following mechanisms: (1) the mechanism determining the price of each bond in function of the interest rate curve, (2) the mechanism that make the interest rate curve move in function of utterly complicated interactions in international financial markets, (3) the mechanism that the portfolio manager uses in order to select the bonds, (4) the mechanism links the return of the bonds to the creditworthiness of the emittent … Well, the limit is exceeded: a bond portfolio is “unnecessary complicated”.
  4. there is complete transparancy about all costs, credit risk and market value — This seems on the first sight to make sense, isn’t it? But let’s have a look at a simple structured product that offers capital protection and increase in function of an index. This is done by buying a long call one the account of the fund. How much cost is in that long call? The fund cannot know this, actually even the counterparty who is selling the call cannot know the actual cost in advance. The seller has mathematical models that make many assumptions (and when reality will be different than the assumptions it will make more or less profit or evel loss) and it adds to that an error margin and a profit margin. These margins re of course unknown by the fund, and each option seller has other models, parameters and margins. It is clearly impossible to know “all costs”. Even a simple bond or equity fund can never predict the exact amount of transactions and hence the transaction costs, even the transaction costs per transaction cannot be predicted exactly. This statement is hence misleading, and an oversimplifiaction. As if someone really would believe that “all costs” can be known in advance.

Do you see any logic behind these regulations, are taxpayers and investors paying regulators … to get discriminated and get worse investment products? Would we not be better of to focus on what really matters? A coherent downside risk measure?

Sure, an understanding of coherent risk measures among law makers and regulators would be a leap ahead, but honestly … there is another story too. From marketing we know that in absence of a clear reason to connect to a brand customers are not that loyal and can be “manipulated” by price, peer pressure, … and novelty. This search for novelty is out of control among producers of shampoo, toothpaste … and investment product providers. This indeed resulted in pruducts that are “unnecessary” complex. We’re talking now about the products where an investor buys basically an OTC option that is highly tailor made for the intermediar. These products would indeed sport things like a bespoke selection of stocks, with special features such as some dropping out or entering depending on this going up or that going down, etc. etc. Indeed for me these products are complicated to understand … even more so because typically sales people –who have little experience with pricing of options– do not really understand them.

It is not the first time that a private banker contacts me with an exclusive product offer “full upside potential AND capital protection”. Investments should in the first place encourage people to save in long term. To get it right it has to be simple enough so that something sensible can be said about the evolution of the return distribution over time so that one can link it with his/her own portfolio and link it to personal goals (and typically one would expect a monotonous link with GDP).

A set of 5 to 10 building blocks are largely sufficient to cater for all needs, fears, wishes and plans in each individual’s portfolio.