Difficult to understand if investment is really protected

By DAVID MOON, Moon Capital Management, LLC
July 3, 2011

When I was a kid, banks would give you a toaster for opening a new account. It seemed like a small generous gesture, but what it really did was add to the bank’s overhead. Since very little of a bank’s expenses are fixed, customers paid for those toasters with higher fees or lower deposit rates.

The toaster complicated the deposit or loan transaction, making it more difficult for the customer to see the true cost of doing business with the bank.

Hiding these costs was not an accident, nor was it the last time this little gambit was used by the financial industry. The toaster is called a “structured product” today and if you want to understand most of them, you’ll need a lawyer, mathematician, finance professor, accountant and actuary - possibly along with an English professor and arbitrator.

These products include things like 130/30 funds, principal protected notes, structured notes and even proprietary mutual funds like the Morgan Keegan funds that forced Regions to pay a $210 million settlement and prompted it to seek a buyer for the beleaguered brokerage firm.

These products are almost always touted as safe, but just as frequently aren’t. A study by The Nation Institute finds that since 2008 investors have lost more than $113 billion in supposedly safe, structured product investments.

According to FINRA (the Financial Industry Regulatory Authority,) many of the brokers who sell them don’t even understand the risks of these things.

Funds that borrow money, invest 130 percent of the fund’s assets in stocks, then take short positions equal to 30 percent of the fund’s assets are called 130/30 funds. They are sold as a perfect stock investment; they allow a manager to buy a significant amount of attractive stocks, while short selling enough expensive stocks to keep his net stock market position equal to the fund’s assets.

Did you follow that? A number of people thought they did five or six years ago, until most of those funds crashed terribly in 2007 – 2008. Now they’re back.

Zurich-based broker UBS has paid more than $10 million in fines and restitution for losses related to its sale of so-called “100% Principal Protection Notes.”

If the principal was protected, how did investors suffer losses? The principal was backed by Lehman – which filed for bankruptcy only months after UBS was actively selling these bonds.

Some principal protected notes only guarantee 10 percent or so of an investor’s principal, or only provide guarantees under certain circumstances.

One thing is guaranteed, however: if the structure of an investment vehicle is so complex that the people selling it can’t comprehend it, you can’t either. It also means that you don’t understand the costs and risks.

And if you don’t understand it, you shouldn’t buy it.

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Last week I bragged about my bargain sneakers I purchased at Walmart. On Tuesday, the insole came unglued and folded painfully underneath my heel. I exchanged them, without incident, before work on Wednesday. While at the store, I also bought six boiled eggs and some sunscreen.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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