Wednesday, May 07, 2008

Reading the Fine Print

It is obvious to the readers of this blog that I have a fondness for "structured equity products", and use them as a tweenie between stocks and bonds on both the risk and reward scales. I was therefore delighted when I accidentally found a recent academic article called "Patterns in the Payoffs of Structured Equity Derivatives", by Brian J. Henderson and Neil D. Pearson. I probably should have been less delighted by their conclusion, that "it is difficult to rationalize the purchase of the SPARQS within the context of any plausible normative model of the behavior of rational investors." (They make it clear that they believe the same to be true of other SEPs.)

Happily, my real-world numbers tell me otherwise. "Fund Manager" tells me that since March, 2001, when I started investing in SEPs, my annualized ROI (with reinvestment, where applicable) for them is about 19-1/2%, while the comparable figure for SPY during the same period is about 3-1/4%. "MSN Portfolio Manager" gives a similar figure for my tweenies; it would be too much trouble to have it produce a figure for SPY. I assume that if I were to look for some representative bond index yields for the same period, they would be even lower.

What is the reason for the difference between my results and theirs? One is that I am a financial genius on an amazing scale, and therefore just by choosing my SEPs and purchase dates carefully, I get results much better than what is typical. Unfortunately, that's just not true. So let's look another possibility: that their results are irrelevant to the real world.

A minor reason for that to be true seems to be one of the mathematical bases for their conceptual conclusion: their conclusion is based on two calculations, one of which is a comparison between the issue price of the SEP and "fair value". Their calculation for fair value, in turn, is based on Black-Scholes. Well, Black-Scholes itself turns out to have some serious problems if compared with the real world. And don't tell me that Black-Scholes is the most accepted model in the world of investing. We're not talking about whether it's popular; we're talking about whether it correctly predicts reality.

However, there seems to be a much bigger reason for the huge discrepancy between Henderson and Pearson's theoretical results and my real-world results: they are measuring something which is irrelevant to the real world. Their almost-real-world total-return calculations, which are obviously much more significant than their fair-value calculations, are all based on the behavior of the securities from the date of issue. Well, as they admit, SEPs are marketed mainly to retail investors, and retail investors normally buy after the date of issue, in the secondary market, just as I do. This gives the real retail investor two enormous advantages that Henderson and Pearson's hypothetical primary market investor didn't have. First of all, the later one gets in date and the closer on gets to the maturity date, the more information is available about the future possibilities of the underlying stock. Even the very up-market issuer didn't have that information when setting the price and terms for the SEP. Secondly, I normally buy SEPs, which are mainly single-equity SEPs, well below the issue price, so that the high coupon becomes a more important part of the total return, and the behavior of the underlying stock a lesser. In effect, my real-world SEPs sometimes approach in behavior a high-yield bond with little default risk.

H. and P. do explicitly mention the distinction between primary and secondary market investors, but only in two sentences of limited scope: "[P]rimary market investors pay on average nearly an eight percent premium for these securities...; [P]rimary investors are paying a large premium for these securities." They do not emphasize that all of their return calculations are based on the less usual case of retail investors buying in the primary market, and they don't even hint at that fact in the three reprises of their conclusion.

The moral of the story: In reading academic research, as in using almost any other investment tools, it is important to read the fine print.


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