It’s commonly held that there are no free lunches. Expressions such as “if you’re not paying, you’re the product” come to mind when people talk about social media, for example. In the case of the investment world, we talk regularly about all the hidden tricks, fees, and gotchas that are designed to “move the customer’s money from their pocket to your pocket,” as Matthew McConaughey said in “The Wolf of Wall Street.” Yet, despite the common wisdom that there are no free lunches, the American public has an inexhaustible appetite for the unbelievable. Today is no different, with the release of exchange traded funds (“ETFs”) that offer the same incredible deal as advertised in many insurance products: “Market participation with a guarantee against loss!” But as you’ll see, this is like oh so many offers of a free lunch: not what it seems.
Understanding “The Promise” of Guarantees Against Loss
First of all, the word “guarantee” is all but forbidden in the land of finance. Nothing will attract the attention of a wrathful compliance officer or regulator like guaranteeing anything to a client. The word guarantee is reserved for things like payments from US Treasuries, the purchase of CDs at an actual bank under the FDIC limit, and structured insurance products. It’s in that last example that the most questionable use of “guarantee” comes into play, as it fundamentally strikes a balance between an insurance company’s existence as a guarantor against the risks of its policyholders and the economics of delivering on the protection against those risks.
In practice, the most appropriate example of where this balance is questionably struck is in the existence of “indexed universal life” or “IULs” and fixed indexed annuities or “FIAs.” These products make a basic marketing claim: “Guaranteed” protection from market loss while receiving “index-like” returns. This leads many consumers of these products to make a few false assumptions:
- That they are investing in an actual investment index like the S&P 500 or NASDAQ 100.
- That they are guaranteed by the insurance company not to lose money.
- That this is a proverbial free lunch.
However, these products do not invest in the underlying indexes. Whether they use popular indexes such as the S&P 500 or offer proprietary indexes, they are not investing in the underlying assets. Rather, they are using a combination of guaranteed products (such as US Treasuries) and a bull call spread. So, for example, let’s say an IUL or FIA is basing its credited return to policyholders on the S&P 500 index. They might take $1,000 of premium and invest $900 in US treasuries and $100 in a call contract based on the S&P 500 index, while also selling a call contract based on the S&P 500 index to defray the cost while also capping the potential upside; the math behind this gets a bit confusing to follow (options trading is the death of many would-be stockbrokers), but effectively, the insurance company is keeping most of the policyholder’s money safely stored in US treasuries while exposing it to the potential for a bit more upside by buying calls that may yield a return greater than then treasuries, but while shielding itself against the potential downside risk of the market by not actually investing in the market.
The lack of a free lunch then kicks in earnest, because while the policyholder here is guaranteed not to lose money due to being invested in the market (because the policyholder isn’t actually invested in the market), the policyholder may still lose money due to insurance costs, riders, fees, and other contract costs built into the policy. Simultaneously, they are also limiting their upside because options contracts do not care about things like dividends or interest payments to shareholders, only the face value of the index they’re based upon. So while an index might be yielding several percent annually in dividends or interest payments, the policyholder receives none of it; they only can make “extra” if the index goes up, and in return, they simply won’t lose money to market losses, though they may lose money due to the costs of the actual product they’ve bought.
Where The Free Lunch Has Become Problematic
All of the confusing math and structures above are exactly that: confusing. This is why the average American consumer is not easily able to follow the way these policies actually function, which, unfortunately, can make such people easily preyed upon by unscrupulous salespeople. Just last week, a client casually mentioned that their employer had a “financial advisor” come into the office to give an “educational presentation” on these policies, only to have me explain after the fact that it was all just one big sales pitch based on the bait and switch of “risk-free returns” when in fact, the policies were simply expensive money-traps. This isn’t to say that all IULs or FIAs are bad or wrong, just that they’re easily marketed to the public because they represent an apparent opportunity for a free lunch when, as we’ve discussed, there is no free lunch.
Yet, the monopoly on this supposed free lunch is apparently about to end.
Competition for Free Lunch Breeds Better Results?
A common argument for the sale of IULs and FIAs in the past has been access to the options strategy utilized and the professional management thereof. After all, nothing is stopping any investor from simply engaging in a bull call options spread strategy for themselves, except for financial sophistication and the discipline to deliver. Yet, this strategy is now coming to the ETF marketplace, with a press release by an investment company stating that they will begin offering ETFs offering the same spread strategy on popular indexes such as the S&P 500, Nasdaq-100, and Russell 2000. Yet, such a strategy can and will suffer from the same risks: while shareholders of the ETFs will have access to the options spread strategy as already described, they will not be without risk of loss, because as we’ve said: there is no free lunch. The products will come with expenses, bid and ask spreads, and so on, and those will inevitably produce a cost drag that mean that in given years where the index from point-to-point is at 0% or less, that these products will lose money (up to 0.69%, as evidenced by the annual expense ratio of the initial product offering.)
The upside to the offering of such products is that they will help undermine the monopoly currently held by insurance companies on offering these strategies. A longtime defense of unscrupulous salespeople of IUL and FIA products has always been that this is “the only way to have such guarantees* against losses,” but the introduction of a securities-based version of the strategy opens the door to a simple question: “Why pay for unnecessary insurance, pay commissions, lock up money with surrender periods, etc. when you could just buy the ETF version instead?”
We of course, look forward to seeing the babbling response of the purveyors of these products for many years to come, but in the meantime, just keep in mind: there is no free lunch. These products are complex and not suitable for the vast majority of investors, and just because a company is offering a product that claims to guarantee you from losing money doesn’t mean that they can deliver on that promise. As the joke goes in the personal injury litigation space: “Owning insurance is simply buying the right to sue your insurance company.” So be mindful that buying products claiming to guarantee you against loss may be simply buying the right to one day sue them for failing to do so.
*Guarantees are rarely that.
A basic statement for compliance: We are not recommending anyone buy an IUL, FIA, or ETF offering a options strategy. Options trading is an incredibly high risk, possibly one of the highest, if not the highest, risk activities in investing. We do not recommend options trading for any individual investor or client, and informing you about how the products discussed above function is not the same as an investment recommendation or personalized advice. If you go and buy options or any of the products discussed above without the assistance of a professional investment adviser and fiduciary who is advising you and accepting liability for advising you to do so, please know that we think you are incredibly foolish for doing so, and all we can do is wish you luck. Also, frankly, whoever that is probably isn’t a fiduciary, so maybe just don’t do it.