Not requiring disclosure can be harmful

By DAVID MOON, Moon Capital Management, LLC
February 3, 2013

The fear of failure is a powerful motivator among all types of people and competitors – including investors.

The same core techniques that football coaches use to motivate their players to sacrifice their comfort in exchange for a shared goal are also used by financial advisors and other sales people.

When things are going well, salesmen prey on people’s fear of missing the next big thing. (See “Internet bubble” for one example.) After a period of difficult investment returns, investors are vulnerable to the promises of unrealistic, or misleading guaranteed returns.

A period like today presents a little bit of each. The massive decline of 2008 is still on investors’ minds, as is the accumulated effect of a similar decline in 2000-02. Yet interest rates are low and most stock investments increased somewhere between 10 and 15 percent last year. Thus is born a new structured product, designed to assuage the twin fears of participating in a disaster and missing another year of outstanding stock returns.

They have fancy names like Buffered or Enhanced Return Notes, but they are just old gimmicks in new packaging. They might promise to pay some multiple of the stock market’s positive performance, while only exposing the investor to a portion (say 90 percent) of the downside.

It sounds fantastic, but that simple description is terribly misleading. I reviewed one particular note that claimed to pay 1.5 times the S&P 500 gain over a fixed period of time – but only with certain caveats. And it capped investors’ return at very modest amounts.

This investment did not include the dividend portion of the index return. That may not sound like much, but if the S&P 500 returns 10 percent in a year, more than 20 percent of that return comes from its current 2.10 percent dividend yield. It is misleading to imply that an investor will receive 1.5 times the return of the overall market if the dividends are excluded.

That wasn’t all that was misleading about this note.

Not only did the stock-return guarantee exclude the dividend return, investors were limited to a total return of 14 percent over the entire life of the investment, regardless of how well the S&P 500 performed. Fourteen percent total, not annualized. If you read the footnotes and do the math, these notes will only provide 1.5 times the S&P 500 capital return (excluding dividends) as long as the overall market returns less than 9.33 percent and more than zero.

The guaranteed down-side protection was similarly misleading.

A “90 percent of the downside” guarantee sounds pretty attractive, until you read and understand what that means. If the market declines 10 percent, the investor gets all of his money back. But the investor would absorb all of the S&P 500 loss in excess of the first 10 percent.

If the S&P 500 declines 30 percent, an investor would lose 20 percent. If the market increases 30 percent, he would make only 14 percent.

The best investors are rational, not emotional. Slick salesman are looking for everyone else.

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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