Ex-post Structured Product Returns: Index Methodology and Analysis
By: Geng Deng, Tim Dulaney, Tim Husson, Craig McCann, and Mike Yan (Apr 2014)
Published in The Journal of Investing, Summer 2015, Vol. 24, No. 2: pp. 45-58.
The academic and practitioner literature now includes numerous studies of the substantial issue date mispricing of structured products but there is no large scale study of the ex-post
returns earned by structured product investors. This paper augments the current literature by analyzing the ex-post returns of nearly 18,000 individual structured products issued by
13 brokerage firms since 2007. We construct our structured product index and sub-indices for reverse convertibles, single-observation reverse convertibles, tracking securities, and auto-callable securities by valuing each structured product in our database each day.
The ex-post returns of US structured products are highly correlated with the returns
of large capitalization equity markets in the aggregate and individual structured products
generally underperform simple alternative allocations to stocks and bonds. The observed
underperformance of structured products is consistent with the significant issue date under-pricing documented in the literature.
Valuation of Structured Products
By: Geng Deng, Tim Husson, and Craig McCann (Feb 2014)
Published in The Journal of Alternative Investments, Spring 2014, Vol. 16, No. 4: pp. 71-87.
The market for structured products has grown dramatically in the past decade. Their
diversity and complexity has led to the development of many different valuation approaches,
and which approach to use to value a given product is not always clear. In this paper
we demonstrate and discuss four approaches to valuing structured products: simulation of
the linked financial instrument's future values, numerical integration, decomposition, and
partial differential equation approaches. As an example, we use all four approaches to value
a common type of structured product and discuss the virtues and pitfalls of each. These
approaches have been practically applied to value 20,000 structured products in our database.
Large Sample Valuations of Tenancies-in-Common
By: Tim Husson, Craig McCann, Edward O'Neal, and Carmen Taveras (Oct 2013)
Published in the Journal of Real Estate Portfolio Management, Vol. 20, No 2, 2014.
In this paper, we value a large sample of tenant-in-common (TIC) investments based on cash flow projections found in 194 private placement memoranda. Our sample of TIC offering documents covers approximately 20% of the TIC industry from 2004 to 2009. Based on the sponsor's projections, we find that the TICs on average were worth 83.6 cents per $1 paid by TIC equity investors. However, we have found that sponsors' cash flow projections overstate likely returns to investors by assuming unrealistically high rental growth rates and unrealistically low vacancy and caps rates.
Adjusting only the sponsors' cap rates alone to rates reflecting market conditions lowers the average valuations by 9.5 cents to 74.1 cents per $1. Adjusting the sponsors' unrealistic rental growth rate and vacancy assumptions lowers the average value further. These low valuations are consistent with average upfront fees and reserves equal to 28% and 12% of equity. Our results suggest that private placement sponsors have considerable latitude in their projections, and that investors should view projected returns with skepticism.
The Priority Senior Secured Income Fund
By: Tim Dulaney, Tim Husson, and Craig McCann (Sep 2013)
Published in the PIABA Bar Journal, 20 (2): 191-206, 2013.
Retail investors are being sold increasingly obscure non-conventional investments. With the Priority Senior Secured Income Fund (PSSI), issuers may have finally gone too far. PSSI is the first registered investment company that invests primarily in leveraged loans and CLOs. Unlike the mutual funds with which most retail investors are familiar, PSSI investors are not able to redeem shares daily at PSSI's net asset value. PSSI is not listed on an exchange and traded like a closed-end fund and so investors will have neither an observable market price nor any opportunity to sell shares in the secondary market.
PSSI, like other non-traded investments, is an extremely high cost offering. Its upfront fees of at least 9% and annual fees of over 8%, in addition to the high cost of its underlying structured finance investments, require persistently high returns on its portfolio to generate a positive internal rate of return for fund investors. The increased risks borne by investors to generate that return are complex and are not likely to be appreciated by brokers or retail investors.
Structured Product Based Variable Annuities
By: Geng Deng, Tim Dulaney, Tim Husson, and Craig McCann (Sep 2013)
Published in the Journal of Retirement, Winter 2014, Vol. 1, No. 3: pp. 97-111.
Recently, a new type of variable annuity has been marketed to investors which is based on structured product-like investments instead of the mutual fund-like investments found in traditional variable annuities. Embedding a structured product into a variable annuity introduces substantial complexity into an investment typically considered conservative. In this paper, we describe structured product based variable annuity (spVA) crediting formulas and how they differ from traditional VAs, value the embedded derivative position for a range of example parameters, and calculate the fair cap levels required to fairly compensate investors for the derivative position. We also provide extensive backtests of spVA crediting formulas using our calculated cap levels and compare the results to their underlying indexes. Our findings suggest that the complexity of spVAs can be used to hide fees and reduce the comparability of variable annuities to other investments in the market.
Private Placement Real Estate Valuation
By: Tim Husson, Craig McCann, Edward O'Neal, and Carmen Taveras (Sep 2013)
Published in the Journal of Business Valuation and Economic Loss Analysis Volume 9, Issue 1, January 2014.
As a result of the Securities and Exchange Commission's relaxation of its prohibition against the marketing of private placements, investors will soon be exposed to a broad array of syndicated commercial real estate investments. Private placement commercial real estate investments are illiquid and so cannot be easily valued by reference to frequent transactions in the same asset in active markets.
We have reviewed over 200 syndicated commercial real estate private placement memorandums and find that virtually all include projected cash flows. This study explains how investors and their advisors can use these projections to develop estimates of investment value. We determine a lower bound for discount rates applicable to the cash flows derived from commercial real estate and apply the methodology to an actual commercial real estate private placement investment. Our findings suggest significant overvaluation by commercial real estate private placement investment sponsors even when using conservative estimates of discount rates.
Structured Certificates of Deposit: Introduction and Valuation
By: Geng Deng, Tim Dulaney, Tim Husson, and Craig McCann (Jul 2013)
Published in the Financial Services Review, Volume 23, Number 3, 2014.
This paper examines the properties and valuation of market-linked certificates of deposit (structured CDs). Structured CDs are similar to structured products -- debt securities with payoffs linked to market indexes -- but while structured products have garnered significant interest in both the financial media and in the academic literature, structured CDs have received relatively little attention. We review the market for structured CDs in the United States and provide valuations for several common product types. Using our methodology, we find significant mispricing of several common types of structured CDs across multiple issuers, which is similar in magnitude to the well-documented mispricing in the structured products market. In particular, we estimate that structured CDs are typically worth approximately 93% of the value of a contemporaneously issued fixed-rate CD. These results suggest that unsophisticated investors may not understand the value, risks, and subtleties of these ostensibly conservative investments.
What is a TIC Worth?
By: Tim Husson, Craig McCann, and Carmen Taveras (Jan 2013)
Published in the PIABA Bar Journal, 19 (3): 373-392, 2012.
Tenants-in-common interests are passive real estate investments which are sold based on two claimed benefits: stable "cash on cash" returns and deferral of capital gains tax through 1031 exchanges. The "cash on cash" returns are found in financial projections in TIC offering documents. Using a stylized TIC cash flow projection based on our review of these materials, we show that TICs use aggressive assumptions to inflate the apparent returns to investors.
Projected cash flows must be discounted to determine whether a TIC investment is reasonably priced or not. A TIC's projected cash flows should be subject to sensitivity analysis to determine the risk of unrealistic projections. This traditional risk-return analysis, as part of a reasonable basis suitability analysis, would have determined that TICs had expected returns which were insufficient to compensate for the risk of their leveraged investments in undiversified real estate and that the claimed tax deferral benefits were small compared to the mispricing in TIC offerings.
Dual Directional Structured Products
By: Geng Deng, Tim Dulaney, Tim Husson, and Craig McCann (Jan 2013)
Published in the Journal of Derivatives & Hedge Funds, (5 June 2014).
We analyze and value dual directional structured products - or simply dual directionals
(DDs) - which have been issued in large amounts since the beginning of 2012. DD's evolved
out of another type of structured product called absolute return barrier notes (ARBNs);
however, DD's lack principal protection and have different embedded options positions, which
have yet to be described in the literature. We find that DDs can be broadly organized into
two categories: single observation dual directionals (SODDs) and knock-out dual directionals
(KODDs). We determine the appropriate option decomposition for these categories and
provide analytical formulas for their valuation. We confirm our analytic results using Monte
Carlo simulation and use both techniques to value a large sample of DDs registered with the
Securities and Exchange Commission up to December 2012. Our results indicate that like
many types of structured products, DDs tend to be priced at a significant premium to present
value across issuers and underlying securities and that the present value of the decomposition
is smaller than the face value net of commissions. We find that DDs with embedded leverage
or a single observation feature tend to be worth less than products either without leverage
or with a knock-out option.
Isolating the Effect of Day-Count Conventions
By: Geng Deng, Tim Dulaney, Tim Husson, and Craig McCann (May 2012)
Day-count conventions are a ubiquitous but often overlooked aspect of interest-bearing investments. While many market traded securities have adopted fixed or standard conventions, over-the-counter agreements such as interest rate swaps can and do use a wide variety of conventions, and many investors may not be aware of the effects of this choice on their future cash flows. Here, we show that the choice of day-count convention can have a surprisingly large effect on the market value of swap agreements. We highlight the importance of matching day-count conventions on obligations and accompanying swap agreements, and demonstrate various factors which influence the magnitude of day-count convention effects. As interest rate swaps are very common amongst municipal and other institutional investors, we urge investors to thoroughly understand these and other `fine print' terms in any potential agreements. In particular, we highlight the ability of financial intermediaries to effectively increase their fees substantially through their choice of day-count conventions.
