Structured Products and the Mischief of Self-Indexing
Published in The Journal of Index Investing, Spring 2017, Vol. 7, No. 4, pp. 16-29.
In recent years, investment banks have issued structured products linked to indexes they create rather than just linking to standardized indexes from Standard & Poor's. In doing so, the issuers create additional difficulties for retail investors to understand these, sometimes complex, investments. We illustrate the potential conflicts of interest created with structured products linked to proprietary volatility indexes although the conflicts are present in other proprietary index based investments as well.
In the 1990s, investment banks switched from underwriting reverse convertibles and tracking securities issued by operating companies like Citicorp and Reynolds Metals linked to their own stock to issuing and underwriting structured products linked to unrelated publicly traded companies like Cisco Systems. This change in investment banks' role led to a dramatic proliferation of new issuances and ever more complicated payoff structures since the underwriters were no long limited to underwriting securities other companies wanted to issue. Investment banks could now issue notes in relatively small denominations linked to publicly traded companies that the brokerage firms could then sell through their retail sales force. The complexity of these notes made regulatory oversight more difficult and allowed issuers to sell structured products with very low issue date values.
How Widespread and Predictable is Stock Broker Misconduct?
Published in The Journal of Index Investing, Summer 2017, Vol. 26, Issue 2, pp. 6-25.
In this paper we reconcile widely diverging recent estimates of broker misconduct. Qureshi and Sokobin report that 1.3% of current and past brokers are associated with awards or settlements in excess of a threshold amount. Egan, Matvos, and Seru find that 7.8% of current and former brokers have financial misconduct disclosures including customer complaints, awards, and settlements.
We replicate and extend the analysis of broker misconduct in these studies. Qureshi and Sokobin arrive at their low estimate by excluding 85% of all brokers, including those brokers most likely to have engaged in misconduct. Applying Qureshi and Sokobin's restrictive definition of potential misconduct to all brokers, we find that misconduct is much more widespread.
We also evaluate Qureshi and Sokobin's claim that its BrokerCheck website provides helpful information to investors seeking to avoid bad brokers and answer the question posed by Egan, Matvos, and Seru: If BrokerCheck data can identify broker misconduct, why don't investors use that data to protect themselves? We find that BrokerCheck is worthless in its current hobbled form, but that it could easily be modified so that market forces might substantially reduce broker misconduct.
Craig McCann's NASAA 2015 Presentation, Investments Through Time
Investments Through Time: The Evolution of Investment Products and How They are Sold.
Fiduciary Duties and Non-traded REITs
Published in the Investments & Wealth Monitor, July/August 2015.
A summary of SLCG's analysis of investor returns in 81 non-traded REITs. Investors are at least $45.5 billion worse off as a result of investing in the 81 non-traded REITs compared to investing in a diversified portfolio of traded REITs. Investors in non-traded REITs over the past 25 years would have earned as much or more investing in short and intermediate term US Treasury securities without bearing the risks and illiquidity of non-traded REITs. More than half of the non-traded REITs' $45.5 billion underperformance results from upfront fees charged to investors in the offerings. The rest of the underperformance results from conflicts of interest which permeate the organization structure of non-traded REITs and which are largely absent in traded REITs.
Non-traded REITs are so inferior to traded REITs that no advisor taking due care could develop a reasonable basis for recommending a non-traded REIT. Advisors recommending non-traded REITs either are not exercising due care or are succumbing to the corrupting influence of the extraordinary commissions sponsors pay for recommending non-traded REITs. The brokerage industry is well aware that recommending non-traded REITs is inconsistent with fiduciary duties.
An Empirical Analysis of Non-Traded REITs
Published in the Journal of Wealth Management, 19(1):83-94, Summer 2016.
We find that returns to 81 non-traded REITs which had listed, been acquired by or merged with a listed REIT or had updated per share values average 6.3% annually compared to 11.6% returns earned over the same period in traded REITs. A significant portion of non-traded REITs' $45 billion underperformance results from high up?front fees that average 13.2%, and largely compensate brokers. The remainder of the shortfall results from conflicts of interest that permeate the organizational structure of non-traded REITs.
Non-traded REITs that list on a major securities exchange almost always "internalize" their management and administrative functions prior to listing. We observe corresponding reductions in expenses, on average equal to 9.0% of revenues, largely attributable to the elimination of payments to affiliated parties. Institutional ownership of non-traded REITs rarely occurs until after both an exchange listing and the severing of management and advisory functions from the sponsor, consistent with our view that non-traded REIT investors suffer from the lack of monitoring and effective mechanisms for shareholder protection.
Ex-post Structured Product Returns: Index Methodology and Analysis
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.
Efficient Valuation of Equity-Indexed Annuities Under Lévy Processes Using Fourier-Cosine Series
Published in The Journal of Computational Finance, Vol 21, No. 2, September 2017.
Equity-Indexed Annuities (EIAs) are deferred annuities which accumulate value over time according to crediting formulas and realized equity index returns. We propose an efficient algorithm to value two popular crediting formulas found in EIAs - Annual Point-to-Point (APP) and Monthly Point-to-Point (MPP) - under general Lévy-process based index returns. APP contracts observe returns of referenced indexes annually and credit EIA accounts, subject to
minimum and maximum returns. MPP contracts incorporate both local/monthly caps and global/annual floors on index credits. MPP contracts have payoffs of a "cliquet" option.
Our algorithm, based on the COS method (Fang and Oosterlee, 2008), expands the present value of an EIA contract using Fourier-cosine series, expresses the value of the EIA contract
as a series of terms involving simple characteristic function evaluations. We present several
examples with different Lévy processes, including the Black-Scholes model and the CGMY
model. These examples illustrate the efficiency of our algorithm as well as its versatility
in computing annuity market sensitivities, which could facilitate the hedging and pricing of
Valuation of Structured Products
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.