Wednesday, February 14, 2007

Retail Structured "Investing"

Regular readers of this blog are familiar with my views on the role played by hedge and private equity funds in collapsing volatility and risk premiums. But it is unfair to point the finger just at them and ignore retail investors who are just as guilty of "selling" volatility and risk, though they may not realize it.

I am referring to the myriad of structured deposit products out there that promise returns based on the performance of commodities, stocks, indexes or currencies, capped on both sides (i.e. maximum return of x%, minimum 0%). The sales pitch is easy and straightforward: you can make as much as, say, 10% if S&P 500 goes over 1600 and your principal is guaranteed. There are also "double-no-touch" products: e.g. you will make 10% if USD/EUR does not go below 1.27 OR over 1.33 within 3 months (please note that all numbers are purely hypothetical). The list of structured products is endless: I have seen offerings on agricultural and energy commodities, equity indexes, currencies, even real estate. Of course it all boils down to this: retail investors are selling volatility and/or buying risk at one level and the arranger of the product turns around and immediately covers it at the wholesale market, pocketing the difference. The whole process naturally drives down overall risk premiums and volatilities.

If you ask any retail investor who bought such a product, he will proudly tell you he is investing in soybeans, stocks or whatever and that he cannot lose, besides. Nothing could be further from the truth, of course, as what he is in fact doing is selling puts, calls or both, backed by exactly that "can't lose" provision: getting no interest on his money for as long as the structured product is slated to run is not exactly "no loss". Recommend to that self-same investor to provide you $500.000 interest-free for 3 years and at the same time to buy a 3 year call on soybean futures and see what he says...likely it will go like this: "What kind of fool do you think I am to give you my money for free? And am I crazy to speculate in commodity options, eh? No sir, I am a conservative, risk averse investor - now get out of my office before I have you thrown out".

One useful observation from all this: the selling of risk premiums and volatility has now arrived and expanded widely into the retail market. When anything reaches retail, however, it is - by definition - fully priced. Watch out above because.. who is now left to sell?