Structured Notes: Buyer Beware!

By Jason Whitby AAA

Forget investing; Wall Street is a marketing and sales machine, and this time it has developed a real stinker of a product that at first glimpse appears to be the answer to your prayers, but really is just one more way Wall Street is going to separate you from your money. The product is the structured note and it advertises its ability to benefit from good stock market performance while simultaneously providing protection against the bad market performance. The cost for this protection is covered by modifying the benefit. It sounds good, but unfortunately, the cost of the protection usually outweighs and undermines any benefit.
What Is a Structure Note?
A structured note is an IOU from an investment bank that uses derivatives to create the desired exposure to one or more investments. For example, you can have a structured note deriving its performance from the S&P 500 Price Index, the Emerging Market Price Index, or both. The combinations are almost limitless. If the investment banks can sell it, they will make just about any cocktail you can dream up.

What Are the Advantages of Structured Notes?
Investment banks advertise that structured notes allow you to diversify your investment products and security types in addition to providing asset diversification. I hope no one really believes this makes sense because it doesn't. There is such a thing as over-diversification and there is such a thing as pointless diversification. Structured notes are the latter.

Investment banks advertise that structured notes allow you to access asset classes that were previously only available to institutions or were hard for the average investor to access. While this might have been the true five years ago, today there are plenty of public funds available in just about every niche possible - perhaps too many. Besides that, do you really think investing in a complex package of derivatives (structured notes) is considered easy to access?

The only benefit that makes sense is that structured notes can have customized payouts and exposures. Some notes advertise an investment return with little or no principal risk. Other notes offer a high return in range-bound markets with or without principal protections. Still other notes tout alternatives for generating higher yields in a low-return environment. Whatever your fancy, derivatives allow structured notes to align with any particular market or economic forecast. Additionally, the inherent leverage allows for returns being higher or lower than the underlying asset which it derives from. Of course, there must be trade-offs, since adding a benefit one place must decrease the benefit somewhere else. As you no doubt know, there is no such thing as a free lunch. And if there was such a thing, the investment banks certainly wouldn't be sharing it with you.

What Are the Disadvantages of Structured Notes?

  • Credit Risk
    Since structured notes are an IOU from the issuer, you bear the risk that the investment bank forfeits on the debt. Therefore, it is possible for the stock market to be down 50% but the note to be worthless. As a matter of fact, the underlying derivatives can have a positive return and the notes could still be worthless - which is exactly what happened to investors in Lehman Brothers' structured notes. A structured note adds a layer of credit risk on top of market risk.

  • Lack of Liquidity
    Since structured notes rarely trade after issuance, it should be pretty clear that they are punishingly, excruciatingly illiquid. Everyone expects to hold structured notes to maturity, but personal emergencies do happen. Additionally, what if the market is crashing and another Bear Stearns or Lehman bankruptcy is looking like a real possibility? Often, your only option for an early exit is the original issuer and taking whatever price they offer, assuming they are willing or interested in making an offer at all.

  • Daily Pricing
    The pricing accuracy is questionable because most structured notes never trade after issuance. Prices are usually calculated by a matrix, which is very different than net asset value. Matrix pricing is essentially a best-guess approach. Who do you suppose gets to do the guessing?

Still Interested?
What if you really don't care about credit risk, pricing or liquidity? Are structured notes a good deal? Given the extreme complexity and diversity of structured notes, we'll limit the remaining focus to the most common type, the buffered return-enhanced note (BREN). Buffered means it offers some but not complete downside protection. Return-enhanced means it leverages market returns on the upside. The BREN is pitched as being ideal for investors forecasting a weak positive market performance but also worried about the market falling. It sounds perfect, almost too good to be true, which of course, it is.

Pulling Back the Curtain
A good example is a BREN linked to the MSCI Emerging Market Price Index. This particular security is an 18-month note offering 200% leverage on the upside, a 10% buffer on the downside and caps the performance at 24%. For example, on the upside, if the price index over the 18 month period was 10%, the note would return 20%. The 24% cap means the most you can make on the note is 24%, regardless of how high the index goes. On the downside, if the price index was down -10%, the note would be flat, returning 100% of the principal. If the price index was down 50%, the note would be down 40%. I'll admit that sounds pretty darn good until you factor in the cap and the exclusion of dividends. The following graph illustrates how this security would have performed versus its benchmark since December 1988.

Figure 1: MSCI Emerging Market Price Index Vs. BREN performance 1988-2009

First, please note the areas marked "Capped!" in the graph showing how many times the 24% cap limited the note's performance versus the benchmark. For example, the 18-month return of the index ending in February 2000 was 107.1%, whereas the note was capped out at 24%. Second, notice the areas marked "Protection?". See how little the buffer was able to protect the downside against loss? For example, the 18-month return of the index ending September 2001 was -49.7% versus the note being -39.7% due to the 10% buffer. Yes, the note did better but a -39.7% hardly seems like protecting the downside. More importantly, what these two periods show is that the note gave up 83.1% (107.1% - 24%) to save 10% on the downside which seems like a pretty bad trade.

Next, we need to remember that the note is based on the MSCI Emerging Market (Price) Index, which excludes the dividends. If you were investing directly in the MSCI Emerging Market Index via a fund or ETF, you would be reinvesting those dividends over the 18 months. This is a very big deal that is mostly overlooked by retail investor and barely mentioned by the investment banks. For example, the average 18-month return for the Emerging Price Index between 1988 and September 2009 is 18%. The average 18-month return for the Emerging Total Return Index (price index including dividends) is 22.4%. So the correct comparison for the performance of a structured note isn't against a price index but against the total return index.

Finally, we need to understand how much downside protection the 10% buffer really provided considering how much of the upside was surrendered. Looking back at the period between October 1988 and September 2009, the buffer would have saved you only 6.6% on average, not 10%.Why? The dividends decrease the value of the buffer. For example, for the 18-month period ending July 2001, the MSCI Emerging Total Return Index was -36.4%, MSCI Emerging Price Index was -38.6%, and the structured note therefore was -28.6%. So for this 18-month period, the 10% buffer really was only worth 7.8% (36.4% - 28.6%) compared to just investing directly into the index.

Conclusion
Structured notes are very complex and few really understand how they will perform relative to simply investing directly in the markets. The illustrations and examples provided by investment banks always highlight and exaggerate the best features while downplaying the limitations and disadvantages. The cost of any perceived protection outweighs and undermines the real benefits. Clearly, investors in structured notes must underweight the cost while overestimating the degree of protection that will be provided. Additionally, there is real risk and disadvantages of structured notes such as credit risk and illiquidity that must be given proper consideration. For all of these reasons, buyers should just pass on this product.

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