The Hedging Game

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Hedgehog

We are not fans of structured products. They break several of the investment criteria that you should ask about before you work with anyone in the financial services industry. They are not liquid. They are not publicly priced. They invest in things that on average do not go up. They promise more than they deliver. And they are laden with fees. To quote Paul Volker, “You can’t hedge the world.” Adding my own admonition, “It costs too much to try.” If that isn’t enough, you probably won’t really understand what you are buying.

It was therefore with much confirmation that I read John F. Wasik’s article chronicling the shortcomings of structured products entitled “The Hedging Game” in Financial Planning magazine. He begins that article with:

“Choosing a structured product – some of the most illiquid, complex and opaque retail offerings coming from Wall Street – is like peeling an onion. Your eyes may water at the cost and complexity.”

The article is long only because the product is complex. Here are some of the highlights.

(1) What you buy may become worthless:

Many investors, such as buyers of Lehman Brothers’ principal-protected notes, have not wound up in the winner’s circle. Lehman’s structured products became worthless after the firm failed. The biggest seller, UBS, has denied any wrongdoing. Overall, investors have lost more than $113 billion in structured products since 2008, according to a study by Demos and the Nation Institute. Many were packaged with bond mutual funds and other investments pitched by brokers as “safe and secure.”

(2) Your returns are low

(3) You can’t sell it.

(4) You won’t understand it.

Some financial planners are leery, for a long list of reasons. As Steve Podnos, a CFP and M.D. at Merritt Island, Fla.-based Wealth Care, puts it: “These rocket scientists have figured out how to minimize a client’s return. You give up liquidity, there’s not much secondary market, you’re a creditor and you don’t own the underlying investment.”

Perhaps my favorite quote in the article comes from NAPFA member David Hulstrom who use to be in our central Virginia study group before moving to Woodstock, Georgia:

When Wall Street builds a better mousetrap, investors should know they are the mouse,” says David Hultstrom, a CFP and CFA at Financial Architects in Woodstock, Ga.

The list of reasons continues:

(5) You can’t hedge the world.

(6) Hedging is too expensive if you could

Hedging always comes at a price. Commissions and other costs, which are difficult to ferret out, range from 1% to 8%, and may rise to 10% for products with puts and calls, according to several planners.

If you are still tempted to purchase a structured product, read the entire article. Then understand the concept well enough so that you can implement it yourself and avoid the high fees and expenses and the long lock up period.

Better yet, find a fee-only fiduciary who sits on your side of the table and will strive to offer you comprehensive wealth management.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818…)