Thursday, March 12, 2009

Who's The Sucker?

"Look around the table. If you don't see a sucker, get up, because you're the sucker." -- Amarillo Slim

A friend sent me this "absolute return" CD.  What's not to love?
  • Positive returns no matter which way the index moves.
  • Guaranteed no loss on capital.
  • FDIC insured.
An absolute return CD is a "structured CD" - that is, it's built out of a mish-mash of derivatives and other instruments that are complex enough that it's hard for the retail investor to understand what's going on here.  But I think Amarillo Slim has it right - if we can't see the sucker, better get up from the table.

I am not sure exactly how banks structure this investment, but a few things strike me as immediately problematic:
  1. The investment is tied to an index, but synthetic instruments that track an index don't necessarily pay dividends.  The real historical long term return on stocks is around 6%, but a significant part of that is from dividends.  Lose the dividends and you're not really getting the kind of returns you'd get out of being in the underlying investment.
  2. These structured CDs have a "barrier" feature.  Basically if the index exceeds some range band, you forfeit all of your interest - you only get your principle back.
This second point is easy for retail investors to ignore.  "If the market really tanks, I'm lucky to have my principle protected".  The fallacy here is to look at the possible returns (if the index tracks in-band) without considering the opportunity cost.  If I offered you a CD returning 0%, you would laugh at me, right?

And even worse, what if the market really out-performs?  Now the market is up and you get none of the up-side!  You don't even get interest.

From what I can tell, this "barrier" is necessary - that is, the banks couldn't offer you a track on the index in both directions without the barrier because the underlying derivatives that make the index tracking possible are more expensive than the interest you're not getting from the CD.

I looked up some S&P 500 option prices for six months in the future.  To create an investment that tracks the absolute value of the change of the S&P to an 8% gain or loss, we need to spend about 8.6% of our capital on the options contracts to make it work.  But the interest returned from the initial cash (in a fixed rate investment) is going to be a lot lower...less than 1% for treasuries, and certainly not 8.6%.

I figure the banks create a new derivative based on the fact that when the S&P goes out of the range they keep all of the returns and you only get the principle.  In other words, when the S&P is highly volatile, you gave them an interest free loan which they used to make money!  They can then write some kind of derivative that is backed by this "free money" and sell that derivative, to recoup the cost of the options above, and maybe make some profit.

One thing is clear to me though: if an absolute return CD is so complex that I can't even figure out how it might work, I certainly can't determine whether the expected return is a good price, or non-competitive.  (I don't even know what derivatives they use, so how do I know if I am being taken?)  I'm not going to buy what I can't evaluate!

(Of course, I'm also not going to buy what I saw on CNBC!!)

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