Can we please stop selling these products – The Global Tofay

Can we please stop selling these products - The Global Tofay Global Today

One of the financial products that has never really caught on in the US or the UK but has been incredibly popular in Germany, Switzerland, and other European countries are structured products. And I have disliked them throughout my entire career. Essentially, they are illiquid products where the only market maker is the bank that issued these products in the first place and where a ton of fees are hidden in the pricing of the derivatives that make up the products.

I will spare you the details of the different types of structured products, but the most common ones are convertible bond structures (essentially a long call option plus a money market investment), a reverse convertible (a short put plus a money market investment) and barrier reverse convertibles (fancy version of reverse convertibles with exotic options to provide additional downside protection).

These products are illiquid, have very high hidden fees, and essentially no benefits for investors. OK, banks like to sell them as products that provide partial downside protection or as tax-efficient products, but the truth is that in almost all cases you are better off not investing in these piles of garbage at all.

A case in point was made by Florian Perusset and Michael Rockinger through a comprehensive analysis of the impact of structured products on a typical 60/40 stock/bond portfolio.

First, let’s look at the risk-return trade-off as more and more structured products are added to a portfolio of stocks and bonds. In general, volatility does indeed drop for small allocations to structured products of 20% or less. But check out the y-axis. The reduction in volatility tends to be in the order of 0.1-0.2%. or about 1-2.5% of the total volatility of the original 60/40 portfolio. Meanwhile, that tiny reduction in volatility is paid for by a reduction in returns in the order of 0.3-0.7%.

Risk-return trade-off for portfolios including structured products

Source: Perusset and Rockinger (2024). Note: CB = Convertible Bond, RC = Reverse Convertible, BRC = Barrier Reverse Convertible.

This already shows that investors give up quite a bit of return for hardly any reduction in risk. The result is a lower Sharpe-ratio the more structured products are added to a portfolio.

But advocates for structured products sometimes say that Sharpe-ratios and volatility don’t matter because structured products are designed to reduce downside risk not upside opportunity. Well, then let’s look at the Sterling-ratio which divides the return of the portfolio by the average annual drawdown plus 10%. In essence, it only looks at return in relation to downside risks.

As the chart below shows both Sharpe-ratios and Sterling-ratios decline as more structured products are added to a 60/40 portfolio. Structured products aren’t even good at doing what they are supposed to do, namely reduce downside risks with limited reduction in upside opportunity. So, can we please stop selling these products to investors? Ah, I forgot. Banks make a killing in fees for selling them, so I guess the answer to my question is: Nope.

Risk-adjusted returns for portfolios including structured products

Can we please stop selling these products - The Global Tofay Global Today

Source: Perusset and Rockinger (2024). Note: CB = Convertible Bond, RC = Reverse Convertible, BRC = Barrier Reverse Convertible.

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