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    Insured Investment Products: The Reality Behind the Hype

    by William Reichenstein

    Insured Investment Products: The Reality Behind The Hype Splash image

    Earn stock market returns with minimal risk of loss!”

    “97% Protected Notes Linked to the Price of Gold.”

    These advertisements are for insured products, which are one type of structured investment products. Insured products promise the upside of a speculative asset, but attempt to limit the downside risk should the asset’s price fall.

    Can these products really live up to the marketing hype? And, more importantly, are they useful additions to an individual investor’s portfolio?

    This article takes a look at the reality behind the hype of these products, by explaining how these investments work—and why I do not recommend them to individual investors.

    All investors should know this by heart: There is no such thing as a free lunch. You cannot get protection from falling prices and also obtain all of an asset’s upside potential. For example, the gold-linked notes described in the ad at the beginning of this article limit the loss to a maximum of 3%, but investors only get some of the upside gain should gold prices rise.

    However, my major concerns with these products deal with their design.

    For a long-term investor, there is a lot to be said for a strategy of rebalancing the portfolio once a year back to an approximately fixed-weight stocks-bonds portfolio, while keeping costs to a minimum. As we shall see, insured products make it difficult to calculate your current asset allocation, and their costs tend to be high. Furthermore, they cause the portfolio to move away from a fixed-weight strategy. In my opinion, such changes in the asset allocation are hard to justify for a long-term investor.

    Structured Products: The Vehicle

    In recent years, there has been a proliferation of structured products. In a structured product, the payoff is based on the value of an underlying stock index or other speculative asset. Moreover, the payoff is usually structured with call or put options to provide non-normal probability distributions of returns.

    Hundreds of these products are listed under structured products at www.amex.com. Most of these products offer insured returns, where there is a limit to the downside loss but an unlimited upside potential. This article examines these insured products, but most of my concerns also apply to the other structured products.

    What Are They?
    One example of an insured product is the S&P 500 Principal-Protected Notes (symbol: ASB) issued on July 27, 1998, and that expire on August 1, 2005. Each note has a $15 principal amount and is an obligation of Salomon Smith Barney Holdings Inc., the issuer. The notes do not bear any interest and are not redeemable by the holder or callable by the issuer prior to maturity, but there is a secondary market for these securities (they are traded on the American Stock Exchange).

    Information from the Web site indicates that, at maturity, each note will entitle the holder to receive $15, plus a payment (the supplement redemption amount), if any, which will equal:

    $15 x (Adjusted Ending Value – Starting Value)
    Starting Value

    The supplemental redemption amount will be based on the percentage increase, if any, in the S&P 500 index, reduced by an annual adjustment factor that is expected to be 1.0% to 1.5%. At maturity, the annual application of the adjustment factor will result in a total reduction in the S&P 500 index equal to approximately 6.79% to 10.04%. The supplemental redemption amount may be zero, but it will not be less than zero.

    Translation: Barring default risk, which is minimal, each note upon maturity will pay off at least $15, thus insuring against a loss. In addition, due to the adjustment factor, the investor receives none of the first 9.2% or so rise in the S&P, but most of the price appreciation beyond 9.2%.

    Another example of an insured product is the Consumer Staples Select Sector SPDR MITTS (stock symbol: CSM, also traded on the Amex) issued by Merrill Lynch. These notes were issued at $10 on March 16, 1999, and promise, at expiration on April 19, 2006, the sum of $10 plus a supplemental redemption amount. From the Web site, the latter is:

    $10 x (Adjusted Ending Value – Starting Value)
    Starting Value

    ‘Starting value’ means the net asset value of one share of the Consumer Staples SPDR Fund on the date the MITTS are priced for initial sale to the public. ‘Adjusted ending value’ means the ending value, as reduced by the adjustment factor. ‘Ending value’ means the average of the net asset values of one share of the Consumer Staples SPDR Fund on five trading days near the maturity date. The adjustment factor is expected to be between 1.6% and 2.0% per year. The Consumer Staples SPDR Fund is an exchange-traded fund that is based on an index of the consumer staples sector of the S&P 500.

    Translation: At maturity, the adjusted ending value is expected to be between 10.6% and 13.07% below the actual net asset value of the Consumer Staples SPDR Fund.

    How do these products compare with uninsured products—a simple purchase of the asset that underlies the insured product?

    As an example, let’s compare two investments, one in simply the Consumer Staples SPDR exchange-traded fund, and the other in the insured product:

    • If someone buys the Consumer Staples Sector exchange-traded fund (stock symbol XLP), he would receive the underlying stocks’ dividend yield (currently 1.9%) plus any gain in XLP’s price. But he would also bear any loss from a decrease in price.

    • If someone instead buys the insured product, he forfeits the dividends for the approximately seven years and the first approximately 13.4% rise in XLP’s price. But he does not bear any downside risk, although that downside risk protection is not a free good.
    How are these products created?

    The next section explains the mechanics of portfolio insurance—that is, how someone can manage a portfolio to generate the returns on the insured products.

    The Mechanics of Portfolio Insurance

    Let’s build two $1 million portfolios. The first will be an all-stock portfolio, while the second will be an “insured product” portfolio that will provide a floor—a guaranteed minimum return—if the underlying stock does poorly and a portion of any gain if the underlying stock does well.

    Creating an Insured Portfolio
    The first portfolio is invested in QRS, a hypothetical non-dividend-paying stock that is selling for $92.

    The second portfolio, the insured product, will invest in a combination of Treasury bills, which ensure a stable, guaranteed risk-free return for a portion of the portfolio, and call options on QRS. For this example, the one-year call option on QRS stock has an exercise (or strike) price of $100—in other words, it offers the right, but not the obligation, to buy one share of QRS one year hence, at $100 a share.

    How much should this call option cost?

    The price of an option can actually be fairly accurately determined using an option pricing model (the Black-Scholes model), a complicated formula that uses a number of factors including the stock’s volatility. Under this model, and using current factors in the formula (including a current risk-free Treasury rate of 1.98% and stock volatility of 20%), the call option to buy one share would cost $4.92.

    TABLE 1. Ending Values of Stock-Only Portfolio and Insured Portfolio
      Portfolio 1:
    100% Stocks
    Portfolio 2:
    Call Options & Treasuries
    Value Today $1,000,000 $1,000,000
    Value in one year if stock price is:    
              $80 $869,600 $971,000
              $100 $1,087,000 $971,000
              $120 $1,304,400 $1,165,500

    Table 1 presents the two investment portfolios that are each worth $1 million today (when rounded). The first is the stock-only portfolio, which consists of 10,870 shares of QRS stock.

    The second is the insured portfolio, consisting of a $952,154 investment in one-year Treasuries and a $47,846 investment in call options. Since each call option costs $4.92, it contains 9,725 call options.

    Table 1 presents the values of these two portfolios if QRS’s stock price one year hence is $80, $100, or $120:

    • If the stock price ends at $80, $100, or $120, then the value of the stock-only portfolio will be $869,600, $1,087,000, or $1,304,400.

    • For the combination Treasury/call option portfolio, the $952,154 in Treasury securities will be worth $971,000 in one year. If the stock price one year hence is at $80 or $100, then the call options would expire worthless and the portfolio would be worth $971,000, for a maximum loss of 2.9%. If the stock price ends at $120, then each call option will be worth $20, [$120 – 100], and the combination of the Treasury securities and 9,725 call options will be worth $1,165,500 [$971,000 + 9,725($120 – $100)]. In this case, the insured portfolio captures 54% ($165,500/$304,400) of the upside gain in the stock-only portfolio.
    Figure 1.
    Ending Values of
    Stock-Only Portfolio
    and Insured Portfolio
    CLICK ON IMAGE TO
    SEE FULL SIZE.
    Figure 1 presents the ending wealth for the stock-only and insured portfolios based on various ending stock prices. Compared to the stock-only portfolio, the insured portfolio’s value will not fall below $971,000. However, it will not fare as well as the stock-only portfolio if the stock price rises. Thus, portfolio insurance provides protection against a sharp fall in price, but it limits the upside gain should the price rise.

    There are other ways to replicate the return from the insured portfolio that I’ve shown in Table 1—for example, combining a stock purchase with put options, which give the right, but not the obligation, to sell stock at a specified price by a specified time.

    Real-World Insured Products
    In practice, most insured portfolios differ from the above example in at least three ways.

    • First, most stock-based insured portfolios are tied to an index, such as the S&P 500, instead of an individual stock. Alternatively, the insured portfolio could be tied to the price of gold or an exchange rate or the price of almost any other speculative asset. Investment bankers form insured products that can be marketed to investors’ fears and speculative interests. Thus, investment bankers are probably developing new structured products tied to prices of stocks, oil, or timber.

    • The second difference is that usually there are not call and put options with the desired expiration dates. For example, the gold-linked insured product mentioned in the opening paragraph pays off based on gold prices four years hence, but there are no gold options that expire in four years. Consequently, the product manager cannot form an insured portfolio of call options on gold and Treasury securities. However, in practice, this does not pose a severe problem because a portfolio of any underlying asset and Treasury securities can be “dynamically managed” to replicate the value of an options-and-Treasuries portfolio. The box below shows how this works—and it may be challenging to understand. The key point you need to focus on, however, is not the actual mechanics, but rather this: A dynamically managed insured product in an asset allocation sense is a combination of the underlying asset plus Treasury bills. To keep the product “insured” (dynamically balanced), the product manager responds to price changes in the underlying asset by selling some of the underlying asset as the price falls and moving more heavily into Treasuries, and conversely buying more of the asset as the asset price rises and moving away from Treasuries. Keep this important point in mind when you consider how insured products affect your portfolio’s overall asset allocation.

    • The third difference is that the issuer will price the insured product to reflect anticipated transaction costs and a profit margin. The option pricing model ignores transaction costs, but these costs exist in the real world. Dynamically managing an insured product requires substantial trading, and the investment banker will obviously include a profit margin in the insured product’s cost.

    Asset Allocation and Costs

    Now we come to the crux of the matter for individual investors: Do insured products offer a useful addition to your portfolio?

    Well, suppose you own an insured product that promises stock market returns when positive but guarantees that you cannot lose more than 3% for the next year. It is similar to the QRS product we created earlier, except the underlying asset is the S&P 500. This section explains my three concerns with this insured product.

    What Is the Asset Allocation?
    My first concern is that owning a portfolio insurance product makes it difficult to calculate your current asset allocation. From the dynamic hedging example, the initial stocks-and-options portfolio translates into a 41.3% stock and 58.7% one-year Treasury bill asset allocation (using the dynamic hedging approach that substitutes a combination of the underlying asset and Treasuries for the option). A frequent dividing point between bonds and cash is one year, but let’s ignore this minor complication and call the initial portfolio 41.3% stocks and 58.7% cash. This asset allocation, however, changes through time. If the stock price increases sharply, almost the entire portfolio is invested in stocks; if the stock price falls sharply, almost the entire portfolio is invested in Treasury bills. In practice, the individual investor never knows the insured product’s effective asset allocation. So someone who purchases an insured product cannot calculate his real asset allocation at any point in time.

    Investment Costs
    My second concern is over the costs.

    Mutual funds must indicate their annual expense ratio to investors. Also, a fund’s prospectus and annual statements indicate the fund’s turnover ratio, which usually provides a good indication of whether the fund’s transaction costs are low or high.

    On an insured product, in contrast, the investment banker sets a price that reflects anticipated transaction costs and a profit margin. In other words, these costs are built into the price of the product and are not explicitly evident to individual investors. Due to the nature of insured products, however, you can be assured that transaction costs are typically high, and profit margins are an extra expense above and beyond the transaction costs. Although the anticipated profit margin is not stated, you should suspect that it is high on these structured products. In short, insured products tend to be high-cost investments.

    The other cost that a potential investor in these products must be aware of is the cost of the insurance protection in terms of lost opportunities, produced in large part by the adjustment factor. Let’s return to the S&P 500 Principal-Protected Notes discussed earlier that were issued in July 1998 and mature in August 2005, and compare an investment in those notes to an investment in an S&P 500 index. The payoff on the notes is based on the closing price of the S&P 500 index, which is an index of prices and, thus, does not reflect returns from dividends. Since July 1998, the dividend yield on the S&P 500 has averaged about 1.45% per year. The investor in the insured product does not get the dividend yield and he gets none of the first portion of price appreciation—a lost opportunity cost that is the price of insurance.

    These costs are not insignificant. Suppose the notes mature when the S&P 500 is 9.2% higher than its value at issue. This ending value corresponds to an average annual price appreciation of 1.25% for the approximately seven years of the note. If the annual adjustment factor is 1.25%, then the notes’ adjusted ending value would be the same as the starting index value—in other words, the notes’ total return would be nil. In contrast, the total return on the S&P 500 would be about 2.7% per year—the sum of the dividend yield and 1.25% average annual price appreciation. Of course, the protected notes would fare better if the market plummets before expiration in August 2005—this is the insurance protection. But these examples illustrate that this protection is not free.

    Dynamic Hedging: How It Works
    To understand dynamic hedging, let’s return to the original single-stock example of QRS stock, but suppose there are no options on QRS stock. Merrill Lynch, however, wants to form an insured product based on QRS stock. The product manager could replicate the options-and-Treasuries portfolio ending value by always investing x% of the portfolio in QRS stock and (1 – x%) in Treasury securities.

    What is the x% that gets invested in QRS stock?

    Here’s where it gets mathematical. The percentage that would be invested in QRS stock is based on a theoretical QRS call option that is priced using the Black-Scholes option pricing model, which includes such factors as the stock’s current volatility and current short-term Treasury rates in the formula. This pricing model provides the theoretical current price for an option at various stock prices. If you plot this on a graph, showing the option prices at various stock prices, this produces a curve, with the option increasing in value as the stock price increases. The slope of the call option’s curve at each stock price is referred to, in option lingo, as the option’s delta—simply put, this measures the change in the option price that is produced when the underlying stock price changes. And the option’s delta is the “x.” That is, by investing x% in stocks, and the remainder (1 – x%) in Treasuries, and frequently adjusting the x%, the dynamically hedged portfolio simulates the options-and-Treasuries insured portfolio.

    Confused?

    Figure 2.
    Call Option Price
    vs. Stock Price
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    Here’s what it looks like: Figure 2 presents a graph of the value of a one-year call option on QRS stock (based on the Black-Scholes option pricing model). Remember, there are no options on QRS stock, but the option pricing model provides the manager with the slope, or delta, needed to replicate the options-and-Treasuries portfolio’s value. At today’s stock price of $92, the slope of the curve is 0.413. This slope indicates that if the stock price rises $1, the option price will rise about $0.413; if the stock price falls $1, the option price will drop about $0.413. So, the product manager would invest 41.3% of the $1 million in QRS stock and 58.7% in one-year Treasury bills. Each day, the manager would calculate the call option’s delta and adjust the stock portion of the portfolio to reflect this delta. Ignoring transaction costs, the ending value of this stocks-and-Treasuries portfolio would be the same as the ending value of the options-and-Treasuries portfolio.

    You can see from the figure that as the stock’s price rises, the curve becomes steeper—in other words, the slope increases. This is the key point: In any insured portfolio, if the underlying asset’s price rises, the slope increases so the manager must readjust the portfolio to reflect the option’s higher slope. For example, if the stock price rose to $95, the new slope would be 0.477, so the manager would sell Treasury bills and buy stocks until 47.7% of the portfolio was invested in stocks. If the price fell to $89, the new slope would be 0.350 so the manager would sell stock and buy Treasury bills until 35% of the portfolio was invested in stocks.

    With a dynamically managed insured product, as the asset price falls, the manager must sell the asset and move into Treasuries. As the asset price rises the manager must sell Treasuries and move into stocks. It is important to remember this point when you consider how insured products may affect your portfolio’s overall asset allocation.

    Long-Term Appropriateness
    My third concern is whether these products should appeal to long-term investors.

    As I outlined in my February 2003 article [“10 Lessons You Should Learn From Recent Market History”; available at AAII.com], there is a lot to be said for a fixed-weight asset allocation strategy with annual rebalancing.

    Consider Mary, a 35-year-old who is saving for retirement 30 years hence. She understands that short-term stock returns are unpredictable. Since she has a long investment horizon, she plans to maintain a stable risk exposure that reflects her stable risk tolerance. In particular, Mary sets her target asset allocation at 75% stocks/25% bonds, which reflects her risk tolerance. If stocks soar next year, she will sell stocks and buy bonds to return her portfolio back to its target asset allocation. If stocks bust, she will sell bonds and buy stocks. As Mary approaches retirement, her target asset allocation will slowly change. Nevertheless, rebalancing allows her to maintain a stable risk exposure that reflects her stable risk tolerance.

    However, insured products, by their nature, produce sharp changes in an individual’s effective asset allocation. Moreover, these changes are the opposite of those that would be pursued by an investor following a fixed-weight strategy. Suppose, for instance, that Mary invests her portfolio in an insured product that matures in two years and the payoff is based on a stock index. Furthermore, assume that, by chance, the initial effective asset allocation of the insured product is 75% stocks and 25% bonds—Mary’s desired asset allocation. If the stock market soars in the first year, the insured product’s effective asset allocation may be 90% stocks—in other words, she would be in essence buying stocks at this point in time. If the stock market goes bust, the insured product’s effective asset allocation may be 40% stocks—she would in essence be selling stocks at this point in time. Both of these actions are the opposite of what she would be doing if she followed a fixed-weight strategy.

    Suppose Mary invests her portfolio in three consecutive stock-based insured products, each with two-year maturities. Her effective asset allocation might begin at 75%-25% stocks-bonds, but in the six years it might be 40%-60% at one time, 95%-5% at another, and 20%-80% at yet another.

    I can think of no reason why her risk tolerance should change so dramatically. It does not make sense for someone saving for retirement some 30 years hence to frequently and dramatically change her asset allocation (and risk tolerance) based on short-term market trends. Whether short-term stock returns are strong or weak, her asset allocation should remain near 75%.

    Insured products are akin to market timing by trend chasers. After markets rise, these products move you even further into the underlying asset. After markets turn south, they move you further out of the underlying asset. This type of timing runs counter to the age-old advice to periodically rebalance your portfolio back to approximately a fixed-weight portfolio.

    Unwanted Insurance

    Many individual investors have seen their portfolios ravaged by volatile markets in recent years. In the aftermath, it is only natural for investors to be attracted to products that promise the benefits of bull markets with the guarantee of minimal, if any, losses. Investment bankers have created numerous structured products, including many with guaranteed minimal returns that are designed to appeal to these investors.

    However, once you understand how these products are actually structured, you can start to understand some of the problems that they introduce to the portfolios of long-term investors.

    Specifically, there are three major concerns.

    First, in practice, individuals who invest in an insured product will not be able to calculate their asset allocation. The effective asset allocation of the insured product, as explained in the dynamic hedging discussion, is x% Treasuries and (1 – x%) of the underlying asset (which might be a stock index, gold, currency, or virtually anything else). But because investors do not know the “x” that exists in the product at any point in time, and because it changes dramatically, these products prevent them from controlling their asset allocation.

    Second, insured products tend to be high-cost investments. The investment banker sets a price on an insured product to include anticipated transaction costs and a profit margin, but these costs are not visible to investors. Due to their nature, we can be assured that transaction costs are typically high on a portfolio backing an insured product. Profit margins are an extra expense, and since they are hidden we should suspect that they are high on these structured products. Individuals investing in structured products are forgoing their ability to control costs.

    Third, there is a lot to be said for a strategy of maintaining a fixed-weight portfolio with perhaps annual rebalancing. This strategy requires investors to sell stocks and buy bonds after a market rise and to sell bonds and buy stocks after a market fall. The stable asset allocation provides a stable risk exposure, which should appeal to the long-term investor. In contrast, insured products are akin to market timing by trend chasers. After markets rise, these products move you further into the underlying asset. After markets turn south, they move you further out of the underlying asset. These changes in asset allocation run counter to the traditional advice and, in my opinion, are hard to justify for a long-term investor.

    In short, individual investors can and should control their own asset allocation, while keeping costs to a minimum. Structured products cause them to forego their control over these key factors.


    William Reichenstein, CFA, holds the Pat and Thomas R. Powers Chair in Investment Management at Baylor University, Waco, Texas. He may be reached at Bill_Reichenstein@baylor.edu.

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