I don't want to bet against the house.

November 22, 2010 7:20 AM

Is it just me, or is there something vaguely twitchy about this investment my broker is suggesting?

My broker at Merrill Lynch is suggesting putting some of my money into something called an Accelerated Return Note (which is offered by Bank of America, which now owns Merrill). Here's how it works as I understand it. You buy the note at a given price, and it has a 14-month maturity, although there's a secondary market so you can sell them before then. The return is pegged to a particular index fund. If the fund goes down by X percent, I lose X percent of my investment, just like I would if I'd bought shares of the fund normally.

So far, so good. Now here's the part I don't get. The note pays triple the return of the index fund, up to a cap that's set when you buy it. It looks like this cap will be somewhere in the range of 15 percent, so I'll use that as my example. So if the fund goes up by 2 percent, I get 6 percent back from the bank. If it goes up by 3 percent, I get 9 percent. All the way up to a 5 percent fund increase where I hit the cap of 15 percent on the note.

If the fund increases by more than 5 percent I'm still getting more than the return, but no longer triple the return. If the fund value goes up 12 percent, I'm still getting 15 percent rather than 36. At 15 percent, I'm back to a straight return of 15 percent, and if the fund goes up by 20 percent, I still get 15 percent and the bank keeps the remainder.

This makes me nervous. If I'm getting triple the actual return of my investment, that money's coming out of the bank's pocket, right? Why are they going to push this note if they think the fund is going to go up slowly and they're going to lose money by getting X percent back and having to pay me 3X?

It seems clear to me that the only way this makes any sense for them is if they think the fund is going to appreciate by more than the cap - in which case they get to keep some of my returns for themselves. In other words, the bank is betting the fund will grow sharply, while encouraging me to bet that it won't. (If I thought the fund was going to grow by, say, 20 percent, I'd just invest in it directly and get the whole 20 percent.)

Basically this seems to be pitting my interests against those of the people handling my money. Recent history has shown that that's a really bad idea, and I'm inclined to avoid it and keep the incentives such that they make money only to the extent that I do. On the other hand, maybe I'm just not figuring the incentives correctly. Does anyone have any experience with these things, or a sense of why this might be a good or bad idea?

posted by Naberius to Work & Money (21 answers total)

Have you asked your broker why he thinks this is a good investment for you, and, more importantly, what's in it for him?

A brokerage would not pitch you an unusual investment like this unless it was structured in some way to give them an advantage, either via fees extracted from you or else fees extracted from some other party.

The best way to answer your question is to figure out what your broker's incentives are here and how he makes his money on this trade.

If you can't determine that or he won't tell you then walk.

And, frankly, if he won't tell you, find another broker.
posted by dfriedman at 7:30 AM on November 22, 2010

I saw this online somewhere this week.

Any sufficiently advanced financial instrument is indistinguishable from fraud.

It was probably meant mostly to be funny and play off the famous technology quote, but still, it seems to fit here. If you don't understand all the incentives at play in an investment, just pass. The worst thing that can happen is that you keep all you money.
posted by COD at 7:31 AM on November 22, 2010 [4 favorites]

It is possible that BofA is simply using this as a way of attracting desperately needed capital now without actually issuing debt. So yeah, they might actually be taking a hit here, but need the money so badly up front that they're willing to risk that. Still, this does smell fishy, especially as BofA actually weathered the 2008 crisis pretty well. That's how they snapped up Merrill after all.

I'm guessing that there's leverage involved in here somewhere, and you haven't talked at all about the fees involved. That right there could make this a possible money-maker for the company. But dfriedman is right: unless your broker is willing and able to explain to you exactly how this is supposed to work, for you, for him, and for the security originator, take a pass.
posted by valkyryn at 7:37 AM on November 22, 2010

Structured notes like this are always a scam. They always involve bigger commissions for the broker, they are generally much less safe then they are presented to you, etc, etc. You can usually replicate most of what they do for a much cheaper price.

The vig here is two fold - your return is capped at 5% levered 3x and the implied commission in the whole thing is doubtless quite large. You have pretty much figured out what the scam is.

If shit goes down that secondary market is not exist (unless ML has pledged to provide liquidity - which I doubt they have)
posted by JPD at 7:38 AM on November 22, 2010

IANAAccountant, but this doesn't sound like you're "betting against the house" or "pitting your interests against those of the people handling your money" because this is not a zero-sum game. They're putting a cap on your winnings, but compensating with this scheme, which doesn't sound fishy. Of course I have no idea if this is a sound investment, but twitchy? I don't think so.
posted by falameufilho at 7:40 AM on November 22, 2010

Actually, scratch what I said and look at what JPD said. The existence of that secondary market and the commissions could be the real deal breaker here.
posted by falameufilho at 7:44 AM on November 22, 2010

Something that might help you make a judgement would be to look at the price history and volatility of the underlying index fund.

Has it had a history of high volatility, saying losing 25% in one period, then gaining 35% in the next? If so, then the instrument Bank of Ameriwidelynch is trying to sell you will ensure you take all the losses, but cap your gains.
posted by de void at 7:56 AM on November 22, 2010

Best answer: Yeah, I think you're getting the right answers here. It's very unlikely that this is a scam, or "twitchy" in some way. It's probably just a bad deal for you. If the index happens to go up somewhere between like 2% and 13%, you probably come out ahead (including ahead of whatever fees / hidden costs). If it happens to go up less or more, you come out behind (behind just a little if it goes down, potentially behind quite a bit if the index goes up substantially more than 15%).

But in expectation, you're losing some money -- that's why they want to sell you this product. You would need a very specific reason for wanting accept some expected loss in exchange for getting this return profile. And it doesn't sound like you have such a reason.
posted by Perplexity at 7:56 AM on November 22, 2010

To clarify when I say "scam" I mean an instrument designed to obsfucate the real underlying economics of the investment in such a way that the buyer is unaware of both the true price of the investment, and the potential outcomes.

By this definition Structured Notes are nearly always a scam.
posted by JPD at 8:00 AM on November 22, 2010 [1 favorite]

If you want this investment and are creative and understand options, you can build it yourself, probably for less.

I don't see quite how they are doing it and don't have time to work it all out, but I am willing to bet that it involves taking your money, buying shares in an index ETF with it, selling calls against the index and using the money from the calls to buy calls on some leveraged ETF like UPRO or something similar. They then probably either hedge whatever exposure they have, or pass it on to you. However they are doing it, they are charging you more for it than it would likely cost you to do yourself.
posted by procrastination at 8:04 AM on November 22, 2010 [1 favorite]

Best answer: "Basically this seems to be pitting my interests against those of the people handling my money."

You have described every broker relationship ever. Your broker's compensation doesn't depend on you earning money. There's theoretically a "Chinese Wall" between your broker and his trading coworkers, but these are regularly broken for profit.

"It seems clear to me that the only way this makes any sense for them is if they think the fund is going to appreciate by more than the cap - in which case they get to keep some of my returns for themselves."

You're also assuming stocks only go up, which is especially not true over a short 14 month term. Here's a very easy way for you to gauge your profits: Futures. Particularly, S&P emini contracts. Looks like the current market predicts a fall in value, if I'm reading that link correctly. You can probably figure out implied probability of profits in options, but I'm not quite sure where to find or read that data. Let me propose an investment strategy for BoA. Take your money, and just hold it. When the market predictably falls, they owe you less than you gave them. Cost of hedging that contract via options is also probably small enough that they make money either way, and you lose more money than if you had just bought those options yourself.

Also, "secondary market" is kind of bullshit. I mean, ask them to provide a quote for a similar such bond.
posted by pwnguin at 8:06 AM on November 22, 2010

It seems clear to me that the only way this makes any sense for them is if they think the fund is going to appreciate by more than the cap - in which case they get to keep some of my returns for themselves.

Well, no; if the fund goes down, you lose and they still pocket their commission.

They can hedge away most of their risk on this investment with options. What I understand about options is that people with fancy computers who study them all day can evaluate them better than I can. (Economists call this 'information asymmetry'; it's one of the things that can break a market's ability to set prices appropriately.) Therefore, I try to stay away from structured products like this.

I think 'scam' is probably too harsh of a word. There's no reason to expect that the investment won't behave as your bank is describing that it will.
posted by Protocols of the Elders of Sockpuppetry at 8:06 AM on November 22, 2010

Best answer: From your description, you are absorbing 100% of the risk, but sharing the profit in a way that encourages the person holding your money to bet as big as possible, and likely losing out on some service fees along the way?

Yeah, no. Avoid.
posted by mhoye at 8:22 AM on November 22, 2010

Best answer: I agree on the commissions, but disagree on the secondary market aspect. To me, the key point is to understand what the underlying index fund is; and also to understand what the term length is and the payment schedule is.

Assuming that it's a straight index fund against, e.g., large cap equity companies (pretty common), and assuming that you are getting one lump payment at end of term, BoA/Merrill is saying:

(a) we would like to have your money for 14 months.

(b) we're pretty sure that we will be able to get greater returns than the index for that money. In particular,

(b.2) we either think it's likely that the market will be down after 14 months (and so we will not owe you the levered amount on profits)

(b.3) or we think that the market will go up like crazy -- more than 10% -- which means we still make a profit on (commission - leverage + getting-to-use-your-money-for-14-months).

This isn't a scam*, it's just a structured deal. If you believe strongly in your heart of hearts that (a) BoA's asset management arms will exist in 14 months, and that (b) the market will rise such that it will be up N% in 14 months where N is enough to compensate you for not having your money, not invest in something more traditional, and also cover the cost of the commission, then the deal is great in my opinion, for you. Compared to some of the semi-exotic mortgages that people have out there, this is pretty tame.

* DISCLAIMER: I am not your, or even a, registered financial advisor; AND further I am an employee of an asset management firm which is part owned by Merrill Lynch (and hence BoA), and in this post am not speaking for my employer, Merrill or BoA.
posted by felix at 8:36 AM on November 22, 2010 [1 favorite]

mhoye: "From your description, you are absorbing 100% of the risk, but sharing the profit in a way that encourages the person holding your money to bet as big as possible, and likely losing out on some service fees along the way?"

This isn't really right. By the description, the returns of the instrument are pegged to an external index fund. The person holding the money isn't encouraged to do or not do anything in particular.

This instrument will provide returns closely related to the returns of the underlying index fund -- specifically, it will provide identical returns if the index fund goes down; higher returns if the index fund returns between 0 and +15%; and lower returns if the index fund returns over 15%.

If there's some particular reason you want that set of returns, rather than the raw set of returns of the index fund, then you can buy the instrument and get those returns. And yeah, they will charge you for that -- probably charging "too much", yeah.
posted by Perplexity at 8:37 AM on November 22, 2010 [1 favorite]

Agree w/ dfriedman. Especially the last line...

And isn't the full service brokerage model dead yet? Consumers don't need these kind of structured bets, ever!

Ever read any of John Bogle's books?
posted by MisterMo at 9:02 AM on November 22, 2010

If the fund goes down by X percent, I lose X percent of my investment, just like I would if I'd bought shares of the fund normally.

If the fund value goes up 12 percent, I'm still getting 15 percent rather than 36. At 15 percent, I'm back to a straight return of 15 percent, and if the fund goes up by 20 percent, I still get 15 percent and the bank keeps the remainder.

Another question to ask yourself (and your broker): how does this compare to buying the index fund itself? You are assuming all of the downside of the mutual fund, but only part of the upside. You come out "ahead" only if the index fund goes up between 0 and 15%. In all other scenarios, your return is the same (if the index fund goes down) or lower (if the index fund goes up by more than 15%). And this doesn't take into account what in all likelihood are higher fees for this investment than just buying the index fund itself.

If you are extremely confident that this index fund will go up between 0 and 15% in this time frame, then by all means go for it. If not, run away.
posted by googly at 9:32 AM on November 22, 2010

Best answer: This is not legal or financial advice, I am not your lawyer or financial advisor. You should consult your own legal and financial advisors before making any investment decision.

I have worked on probably close to 500 structured note transactions for different investment banks. To be clear, you're not betting against the house; the bank will be perfectly hedged on the transaction--they don't care whether the market goes up or down. They make no money whatsoever on the movement of the index. People get fired for leaving the bank with exposure to the underlying on these deals.

The bank generally views these as a combination of puts and calls at different strikes; you're buying three calls at 100, selling three calls at 105, and selling a put at 100. The purchased calls entitle you to a leveraged upside above the current 100 price, whereas the sold calls entitle the holder to the upside above 105, so your return is capped at 115 (i.e., 3x the appreciation from 100-105). The put shoulders you with the downside below the current price. The option premium on purchased call and the sold calls and put will offset each other (fully or partially), and the bank rolls the costs together into the fee. The fee on structured notes are juicy. Plus, the bank has your money during the term of the note.

These products have been pretty common in the public markets since the introduction of the well-known seasoned issuer rules ("WKSI") in 2005 allowed investment banks to issue notes using a streamlined prospectus supplement that references a larger prospectus on file with the SEC under a shelf registration statement (i.e., the bank would register something like 200 billion in securities to be issued in the future, which could be debt, structured notes, options, warrants, units etc.--but we'll tell you what they actually are later when we sell them). This allowed the banks to come up with very nimble products for average consumers--that is, instead of having to register a gigantic prospectus for each offering (which takes a lot of time and money), they would file a short (4-8 page) term sheet. This allows the banks to make pretty shrewd pricing--so today the S&P is hot, so they sell 3x notes because that's what investors want, but tomorrow the DJIA is looking wobbly, so they sell 2x notes with a 10% buffer on the downside, because the investors want some protection against loss. When I was working on these kinds of products, they could easily be marketed and priced in the course of just a few hours.

As with all investments, you should make sure you really understand how it works, how it fits into your portfolio, who the issuer is, and who is making the money (keep an eye on those fees!). Structured notes aren't for everyone--for instance, I've never bought one, and I spent years working very closely with them.

Again, this is not legal or financial advice, and I am not your lawyer or investment adviser.
posted by Admiral Haddock at 9:44 AM on November 22, 2010 [7 favorites]

If you don't understand it, don't invest in it.
posted by spilon at 12:21 PM on November 22, 2010

what the underlying index? it would seem bofa expects it might go up more than 15% .
posted by 3mendo at 6:11 PM on November 22, 2010

(seconding the opinion that the secondary market is going to be a joke)
posted by 3mendo at 6:13 PM on November 22, 2010