Barrier investments?

[explanade]

Just was talking to a rep. at a brokerage where I recently exercised stock options.

They're offering me access to what they claim are investments only available to corporate customers, such as CDs in the secondary market (not that unique but on their web site for "retail" customers, they don't show up).

But she was talking about "barrier" investments offered by banks like JP Morgan, UBS, HSBC. One she talked about was something tied to the Russell 2000 index.

You invest a minimum of $10k, no transaction fees because any costs are priced into the terms.

Your principal is protected. The term is 18-months. In the case of this one barrier investment, which closes in 2 weeks, if the Russell 2000 is within 27% higher or 27% lower than at the time of the investment, you would get your principal back plus the difference.

If the Russell 2000 is down 20%, then you get a 20% gain. Similarly, if the Russell 2000 is up 25% in 18 months, you get a 25% gain.

If the Russell 2000 falls outside the plus or minus 27% range, then you just get your principal back. In other words, your money has had zero return but your principal is intact, other than losing some purchasing power in real terms.

Has anyone ever heard of these barrier investments? This is new for me.

 

[cute fuzzy bunny]

Pretty easy. You're going to get your principal back plus any gains or losses, minus a bunch of trading costs that are "priced into the terms".

You'll make less or lose more than if you invested directly into the russell 2000.

Santa Claus wont by by for another ~3 months...

 

[cjking]

This reminds me of "structured products" that were retailed in the UK several years ago. I remember one product in particular which was quite legally advertised as having tiny management fees. What regulation didn't require them to explain was that all of the invested money (after deducting the fee) would be invested in a derivatives contract with a single counterparty, who had devised and priced the complex derivative. The profit they built into the price was unkown and unknowable to consumer and financial advisors, and not reflected at all in the advertised management charge they were legally required to publish.

 

[boutros]

Its a structured note. Basically you are buying a bond that pays a lump sum based on an underlying index's performance. The issuer hedges the liability with derivatives and profits from a spread of what it costs to hedge vs sales price. I work for an RIA and we use these for commodity exposure (so does PCRIX) but nothing else. The real cost is about .8%/yr for the products we buy. For a retail investor it might be significantly higher.

 

[FUEGO]

So in 18 months you get a return of principal plus the absolute value of the price change over that 18 month period (as long as the absolute value of price change is under 27%). Otherwise you get a return of principal?

The small cap index (Russell 2000) is typically more volatile than the S&P 500 (for example). This would make it more likely to see returns more than 27% (or less than -27%). I took a quick look at the quarterly returns for the Vanguard Small Cap Index (not Russell 2000 but MSCI US Small Cap 1750 Index now - ie similar to Russell 2000; this fund was Russell 2000 until 2003).

Out of the last 40 quarters, 35 unique return periods were available for testing. Of these 35 periods, the absolute value of 18 month returns were under 27% in 26 periods (or 74% of the time). The absolute value of returns were greater than 27 in 9 periods (or 26% of the time). In other words, looking back on the last 10 years, you would get a payout only 74% of the time.

Additionally, 9 out of 35 periods (26% of periods) paid out 7.5% or less. I used 7.5% as the threshold of what one would expect to earn from a fixed income investment for 18 months (a CD or something?). In other words, a total of 52% of the time you would have been better off investing in a fixed income product yielding 5% per year versus this structured product.

The average return of the 35 unique periods was 9.4% with standard deviation of 8.86%. This return was almost as high as the 10.1% return of the Vanguard Small Cap Index Fund. However the returns going forward (out of sample) may not be as good as they were in-sample.

 

[cute fuzzy bunny]

Really short answer: its a way for an investment outfit to charge you 1-2% for an index fund.

 

[FUEGO]

Really short answer: its a way for an investment outfit to charge you 1-2% for an index fund.

I think it is a touch more complicated than that. I'm sure they are getting their fee.

But it's a crap shoot that would only pay out more than fixed income about half the time (historically speaking). What's the point of the investment? Reduced volatility of returns without sacrificing a whole lot of return (based on in-sample data)?

 

[Art G]

Shorter answer: It's a derivative product. RUN!!

 

[cute fuzzy bunny]

What's the point of the investment?

Its a way for an investment company to get a normally conservative investor to put money into a very volatile investment that offers a suggestion that they will enjoy most of the upside with less of the downside, with "principal protection". Almost any way it turns, the investment company makes money. And they do so with money from a customer that probably wouldnt have bought the bare product, and certainly not from them.

 

[FinanceDude]

Just was talking to a rep. at a brokerage where I recently exercised stock options.

They're offering me access to what they claim are investments only available to corporate customers, such as CDs in the secondary market (not that unique but on their web site for "retail" customers, they don't show up).

But she was talking about "barrier" investments offered by banks like JP Morgan, UBS, HSBC. One she talked about was something tied to the Russell 2000 index.

You invest a minimum of $10k, no transaction fees because any costs are priced into the terms.

Your principal is protected. The term is 18-months. In the case of this one barrier investment, which closes in 2 weeks, if the Russell 2000 is within 27% higher or 27% lower than at the time of the investment, you would get your principal back plus the difference.

If the Russell 2000 is down 20%, then you get a 20% gain. Similarly, if the Russell 2000 is up 25% in 18 months, you get a 25% gain.

If the Russell 2000 falls outside the plus or minus 27% range, then you just get your principal back. In other words, your money has had zero return but your principal is intact, other than losing some purchasing power in real terms.

Has anyone ever heard of these barrier investments? This is new for me.

Run away.....they make equity index annuities look like a great deal.......

 

[explanade]

Yup, that is how they positioned it, as an alternative to fixed-income, offering principal protection.

Thanks for the statistical analysis Fuego.

 

[Art G]

You only thanked Fuego?? WELL! I never!!!

 

[ladelfina]

These kinds of products are widely promoted in Italy.. usually on some "basket of stocks". It did always smack to me of an annuity-type thing, but I have no experience with them.

 

[FinanceDude]

Yup, that is how they positioned it, as an alternative to fixed-income, offering principal protection.

Thanks for the statistical analysis Fuego.

The only ones JPMorgan has that are intriguing are the internal structured notes they use with private banking clients. Of course, you need $25 million or more to be a private banking client, but I digress.

In 2004, they were offering a 5% return for 6 months, or 11% for 12, using a basket of foreign currencies that they hedged. JPMorgan originated and backed the notes, and I heard they did quite well with them..............

 

[cute fuzzy bunny]

In 2004 I got a sandwich from Subway, and it was unusually good. Turns out they didnt get their delivery of crappy bread so the manager bought some good bread at a nearby store to tide them over.

That might happen again. Maybe even at the same Subway!

 

[Canadian Grunt]

Easy decision really. As Warren Buffet prescribes. If you don't understand the product 100% then don't invest. Based on what you described give the investment a pass whether it is good one or not.

 

[Hamlet]

Hear, hear!

I don't get this desire for everyone to make these crazy complicated investments.

I think that the next decade is shaping up to be a great one for stocks. Just buy a few index funds and ride the wave up, baby!

If you want to get really fancy (and there is no good reason to), you can buy some individual stocks of good companies. I think MSFT is a steal right now.

If the volatility of the stock market scares you, add some bonds, a little REIT exposure, a little gold if you must, etc.

If the volatility of that diversified group of investments scares you, increase your cash.

Don't buy these crazy goofball products, though!

Easy decision really. As Warren Buffet prescribes. If you don't understand the product 100% then don't invest. Based on what you described give the investment a pass whether it is good one or not.

 

[Art G]

I think it's a heck of a stretch to go from, "don't buy crazy products" to "just buy index funds and gold".