The High Cost of Complexity
Key Takeaways
Financial institutions being accused of mis-selling products for profit is a tale as old as time.
There is no viable way for an investor to easily check the cost of complex and structured investments before making a decision.
These products are often sold and marketed as “without a transaction or upfront fee” giving the impression that it is free, but there are actually numerous embedded and hidden costs.
Remember, if something sounds too good to be true, it usually is. Always spend more time asking about and understanding its risk, rather than its return.
Life is very simple, but we insist on making it complicated.
— Confucius
A few weeks ago, the news reported that South Korean investors had lost over S$5.7B in structured products tied to Hong Kong listed Chinese stocks.
SEOUL – Ms Park Soon-ja spent five decades working as a cleaner to build her life savings. Now, more than half of her 660 million won (S$649,000) has been lost after the South Korean retiree invested in a structured product so complex that a regulator said even the bankers who sold it struggled to understand how it works.
The 75-year-old is one of hundreds of thousands of South Koreans who were sold equity-linked securities (ELS) tied to the Hang Seng China Enterprises Index (HSCEI) – a gauge of Chinese stocks listed in Hong Kong – by some of the nation’s most prominent lenders and brokerages.
— The Business Times, 30 Apr 2024
This is incredibly sad news, since a lot of the people who lost money were ordinary investors who had just lost their life savings. Unfortunately, this is not the first time that financial institutions have been accused of mis-selling products for profit, and as long as their revenue models do not change, then it is unlikely to be the last as well. There are numerous examples across recent times alone:
Many investors would be familiar with complex investment products that claim to produce higher returns. These products are usually only available to the rich, giving them an air of sophistication and desirability, that may actually be unfounded. After all, it was these highly-engineered products and financial derivatives which were the primary causes of the 2008 global financial crisis, with many losing a lot of money in products that were rated as “investment grade”.
Why then do so many financial institutions still pour time and effort into manufacturing and marketing such products? Are they truly motivated by wanting to give investors a higher return? Unfortunately, it is highly unlikely that such products exist from altruism.
For instance, such products typically have a high embedded, or hidden, fee. Typically, the fees and other costs for stocks and unit trusts are transparent and easily compared in the marketplace. You know what the transaction cost is, the expense ratios, and the investment management fee. With this transparency, it is more difficult to overcharge investors.
However, complex and structured investments are usually unique to the financial institution that created them. You would require a deep knowledge of the underlying instruments which would involve derivatives; you would also need to know the actual market pricing of those instruments, and only after assembling them together would you be able find out the true price / cost of the offering. Thus, there is no viable way for an investor to easily check the cost before making a decision. These products are typically sold and marketed as “without a transaction or upfront fee” giving rise to the illusion that it is free, when in reality there are numerous embedded and hidden costs.
Brian J. Henderson (George Washington University) and Neil D. Pearson (University of Illinois and Urbana-Champaign and MIT) highlight in their research paper “The Dark Side of Financial Innovation” that investors on average, pay a premium of about 8% when buying SPARQs (Stock Participation Accreting Redemption Quarterly-pay Securities). Local investors would recognise these as Equity Linked Notes or ELNs. If you are paying this type of fees, then the odds are stacked against you if you wish your investments to outperform.
In another study titled “Strategic price complexity in retail financial market“ Bruce Carlin from UCLA found that as competition increased, financial firms deliberately increased product complexity instead of becoming more transparent to make price comparison difficult, allowing them to charge higher fees at the expense of investors.
Ironically, the reason these products still exist is because investors want them. A Morningstar article on structured products noted that the idea behind many of the derivative investments available is actually logical. After all, nobody likes losing money but would like to participate even partially in a stock market’s appreciation. So many of the products out there claim to provide a guarantee of giving your capital back (if something goes wrong) with a bonus upside if some underlying investment does well.
On the contrary, someone who wants to invest but cannot take losses even over the long term is actually not a real investor. They are actually savers who should rightly stick to the extremely safe instruments. Because even if the structured investment returns your capital to you after a few years without upside because the bet didn’t pan out, the investor is left worse off as the money he or she received can now purchase less goods and services thanks to inflation.
Another reason why investors are drawn to these complex products could be the highly optimistic projections they offer, which are far above the market norm. A study titled “Structured Investment Products and the Retail Investor” by Carole Bernard and Phelim Boyle found that the sellers of such investment products tended to overweight the maximum return probabilities, i.e. a lot of the returns expectations did not pan out in the end.
Finally, sometimes investors view these products like a status symbol. The way they are portrayed as investment options for the wealthy and those “who have enough assets” can make investors feel sophisticated and discerning as they are able to afford access to those venerated financial institutions and banks.
Writer Mark Twain is frequently credited with the aphorism: “History doesn't repeat itself, but it often rhymes.” We may not see the implosion of the type of structured investment losses we have seen so far, but it is likely to take another form in the future. If you feel that such a product is the ideal investment for you, consider; what are your other cheaper, more efficient, and easier to understand options.
Remember, if something sounds too good to be true, it usually is. Always spend more time asking about and understanding its risk, rather than its return. More often than not, your best option would be to stick to simple, easily understood investment instruments. This is the reason why two main tenets in our investment philosophy are to put risk first and avoid expensive strategies.
If you are unsure of the products that you are holding or about to buy, want deeper insights on how to build a proper portfolio and want a second opinion, come and chat with us.
