Having done a Masters in Applied Finance I can tell you that when you distil the core of almost all financial products and businesses, the trick, the “con”, all comes down to what interest rate you can charge and in particular, the more complex the financial instrument/product the easier it is to camouflage the knife being twisted into the customer.
For example. One of the most enlightening and practical (rather than theoretical) units of my Masters was called “Financial Product Marketing”. In this unit a very talented tutor helped us rip apart the PDS - product disclosure statement (brochure) - for a capital guaranteed leveraged equity product from a very well known Australian financial institution. When, as we were taught, the definition of financial happiness is the expectation of an improvement in your standard of living, you begin to understand what ‘selling’ involves. It involves telling people that if they buy this product their standard of living will improve…in the future. On that basis selling product in this industry is pretty easy. Promise a better future and “they will buy”. Promise, as this product did, a better future (high return using leverage) with no risk (offer a capital guarantee) and they will buy more.
We thought we were being taught how to structure a financial product for a client, but it turned out our talented tutor was teaching us the essence of financial product rorting – how to structure a financial product for the provider, not the client. It was a course in how to earn as much as possible from a client and how to hide that from the client.
This was the 1990’s and disclosure rules have tightened up but it still serves as a good example of some of the basic principles of how to root a client with a fancy brochure.
In this case the product marketing said that you could ‘invest’ a small amount of money (say $20,000), the product provider would leverage it up for you (turn your $20,000 into $100,000 by lending you $80,000), the product provider would invest the $100,000 in equities and, and here was the hook, the product provider would guarantee that you did not lose any money. Hence the description, a leveraged, capital guaranteed, equity product.
And this is how it worked:
- The basic game was to get you to borrow money.
- Lock you into at as high an interest rate as possible.
- Make the product complex so it was impossible to determine what bottom line interest rate you were paying.
- Combine all the different fees (interest rate plus hedging costs, plus admin costs, plus any other clever sounding costs) in one lump sum fee.
- Make the fee payable upfront. Whoopee it’s a tax deduction so paying early is a good thing (??)
- Deliver on their ‘capital guaranteed’ promise by fully hedging all risk on the shares bought by writing options over all equity positions (this is really expensive and they charged you the full cost of the options AND added a margin to that cost for ‘admin’). Another example of complexity giving them another opportunity to add a margin.
- Leave the product provider with no risk.
- Leave the client with all the risk on the assets should a market catastrophe occur – and have a list of excuses ready to go should the product turn out not to be capital guaranteed in all events after all.
The brochure for this 1990’s leveraged capital guaranteed equity product made it look pretty sexy. Fancy brochure, great photos of beautiful successful people, nice paper quality, fancy jargon. A brilliant example of marketing.
Despite studying a Masters in Applied Finance it still took us all a while to understand the bloody thing but in the final analysis it turned out that the client was paying a total fee plus interest of around 16% pa. 16%!
No-one makes money paying 16% for an equity investment. Equities if you are lucky return around 10% a year. Doubly amusing, you paid the $16,000 first year cost on a $100,000 portfolio up front and triply amusing, you paid interest on that $16,000 as well. The product life was five years, presumably because by then they would have stopped laughing long enough to sell you another product.
It was a completely inappropriate product for the clients it was being pitched at (people who wanted a guarantee they wouldn’t lose money).
It left me wondering how this completely inappropriate product had made it this far. The answer is clear. Because people buy them. But they surely can’t understand them.
Inappropriate financial products are everywhere and they are well dressed and well presented.
The basic elements include:
- Lend money.
- Charge interest.
- Make it complex.
- Use the complexity to add a margin.
- Throw in as many one-off fees as you can.
- Get the client to pay interest early.
- Leave the client with all the risk.
- Wrap it all up in a glossy brochure.
So how do you survive the world of financial product trickery?
Here are a few truths and tips about buying financial product:
- Don’t expect the law to protect you, no-one can protect you from your own stupidity in your own living room.
- Take responsibility yourself. Have your wits about you. Common sense will suffice. You are your only defence.
- Most dodgy products are flashing warning signals. If the salesman has travelled 100km to see you at 10.30pm at night then something’s wrong.
- Remember the golden rule. If it’s any good you wouldn’t be offered it. If you get offered it you don’t want it.
- If you don’t understand it don’t buy it. Complexity is camouflage.
- Don’t put much in any one product.
- Be very careful borrowing to invest. There aren’t many (any) asset classes that will reliably return you more than the cost of borrowing. There aren’t any that will return it without a risk.
- If you are buying a dressed product you are almost certainly paying more than market interest rates.
- Reward is always balanced by risk. You will be told about the rewards. If you can’t see the risks you clearly don’t understand.
- Don’t be rushed. There are a million financial products out there. You don’t “need” to buy this particular one.
- Anyone selling you a return of greater than 10%pa either has his fingers crossed behind his back, is lying, hoping or is selling you a greater than average risk.
- Anyone earning a commission of more than 2% is selling something hard to sell you probably shouldn’t buy.
Your stupidity is directly proportional to how unrealistically rich you want to be. Only the financially ambitious (to use a polite expression) sent money to Philippines based investment scammers.
As I’ve said before, “Normal (life, health, home, the kids, a beer, the routine, sport on the telly) is good”. Don’t ever risk “Normal” by buying into the unlikely. There are no short cuts.
High yielding financially engineered products are designed to sell, not to achieve a high total return. They can tell you they are earning a yield of 10% but your capital will be chewed up in the background. Nothing for nothing. Nothing that yields 10% risk-free does.
Source: Marcus Today - 26 April 2019