You can tell that investors are starting to get jittery again. Every time the market stalls out after a nice run, financial companies start putting away products that are based on investor greed and instead pull out the fear-based investments, promising protection from the next stock market crash. Unfortunately, the complicated way that these products work often costs you far more than that protection is truly worth.
Structuring your financial life
The latest wrinkle on an old theme comes from companies trying to appeal to a mixed set of investing goals. On one hand, no one wants to lose money in the stock market. But with conservative investments like bonds and bank CDs earning very little interest, investors also want a chance to participate in the upside of stocks.
The answer that Deutsche Bank (NYSE: DB), UBS (NYSE: UBS) and AXA (Other OTC: AXAHY.PK) have hit upon is based on an old product, the structured note. Historically, structured notes allowed investors to get a fraction of the upside from the stock market while providing complete principal protection if the stock market were to fall. The resulting returns therefore fell into a narrower range, giving investors in the notes far less volatility than they'd have if they invested directly in the stock market.
This time around, though, there's a new problem with these products: They don't give you complete protection. According to the Wall Street Journal, a UBS product only gives you principal protection if the S&P doesn't fall more than 30%. If it pierces that level, known as the downside cap, then you could be stuck with the entire loss. Meanwhile, if the S&P rises, then investors get 1.5 times its return up to a maximum of 58.6%.
The world of complicated investments
These aren't the first products that have ever been designed to address a very particular set of market conditions. Investment firms Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS), as well as banks Citigroup (NYSE: C) and Barclays (NYSE: BCS), have all offered variations on principal-protected securities for years, with returns linked to any number of reference indexes.
In addition, you can find all sorts of other structured products designed to meet other investing goals. Reverse convertibles, for instance, are linked to individual stocks and offer an attractive dividend yield that's well above what the stock itself pays. The trade-off, though, is that when the security matures, you either get your money back or a certain number of shares of stock, whichever is worth less. Often, that works out well for the investor, but during bear markets, the extra income doesn't come close to offsetting the losses from having to accept stock at a reduced value.
Despite all the different styles of bells and whistles these investments offer, the one thing they have in common is that they're unnecessarily complicated. Rather than giving you exposure to a simple investment, deciphering all the rules that establish exactly how much money you earn (or lose) can be difficult even for securities experts.
The better way to protect yourself
The reason so many investors find these securities attractive is that they don't require you to accept the ups and downs of a diversified portfolio. Rather than allowing you to mix stocks, bonds, and other investments to create a risk profile you can be comfortable with, structured notes instead appeal to the desire never to see any of your investments go down.
Among their other downsides, structured notes are costly. The UBS product described above, for instance, charges an underwriting fee of 2.5%. That's a lot to take off the top for an investment that doesn't provide perfect protection.
It's never pleasant to see your portfolio go down. But don't let your memories from two years ago convince you that you need to give up on the potentially unlimited gains that stocks provide. Even when structured notes work the way you think they should, they don't always do as good a job over the long run as a simple diversified set of investments.
Instead of costly structured notes, low-cost ETFs can fulfill a number of useful roles in your portfolio. Click here to read The Motley Fool's free report, 3 ETFs Set to Soar During the Recovery.
