Have you ever read a book written by an ex-Wall Street trader? As in, a trader who worked at an investment bank at some point during his career? The message is always the same. If investment banks didn’t have clients, they wouldn’t exist. That might sound logical, but the point is that investment banks aren’t relying on their investments to keep in business. They were relying on your funds that you’re trusting them to invest.
That means that investment banks are in many ways, sales, and marketing machines dedicated to separate you from your money with their products. And the marketing drums have been beating overtime of late with one product in particular. It's the structured note, and it advertises its ability to benefit from excellent stock market performance while simultaneously protecting the bad market performance.
To the ordinary investor, structured notes make perfect sense. Who wouldn’t want upside potential with downside protection? What isn’t revealed is that the cost of that protection usually outweighs the benefit. But that’s not the only risk you’re taking on with a structured note. Let's take a closer look at these creatures.
What Is a Structured Note?
A structured note is a debt obligation – basically like an IOU from the issuing investment bank – with an embedded derivative component; in other words, it invests in assets via derivative instruments. A five-year bond with an options contract, for example. A structured note can track a basket of equities, a single stock, an equity index, commodities, currencies, interest rates, and more. For example, you can have a structured note deriving its performance from the S&P 500 Index, the S&P Emerging Market Cores Index, or both. The combinations are almost limitless, as long as they fit the concept: to benefit from the asset's upside potential while also limiting exposure to its downside. 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 specific investment products and security types in addition to providing overall asset diversification. I hope no one 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 also often advertise that structured notes allow you to access asset classes that are only available to institutions or hard for the average investor to access. But in today’s investing environment, it’s easy to invest in almost anything via mutual funds, exchange-traded funds (ETFs), exchange-traded notes (ETNs), and more. Besides that, do you 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 the derivative's returns being higher or lower than its underlying asset. 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
If you invest in a structured note, then you have the intention of holding to maturity. That sounds good in theory, but did you research the credit worthiness of the note's issuer? As with any IOU, loan, or another type of debt, you bear the risk that the issuing investment bank might get into trouble and forfeit on its obligation. If that happens, 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 (see: Case Study: The Collapse of Lehman Brothers.). A structured note adds a layer of credit risk on top of market risk. And never assume that just because the bank's a big name, the risk doesn't exist.
- Lack of Liquidity
Structured notes rarely trade on the secondary market after issuance, which means they are punishingly, excruciatingly illiquid. If you do need to get out for whatever personal reason – or because the market is crashing – your only option for an early exit is to sell is to the original issuer and that original issuer will know you’re in a bind. Therefore, the original issuer will not give you a good price – assuming they are willing or interested in making an offer at all.
- Inaccurate Pricing
Since structured notes don’t trade after issuance, the odds of accurate daily pricing are very low. Prices are usually calculated by a matrix, which is very different than net asset value. Matrix pricing is essentially a best-guess approach. And who do you suppose gets to do the guessing? Right – the original issuer.
Other Risks You Need to Know
Call risk is another factor that many investors overlook. For some structured notes, it’s possible for the issuer to redeem the note before maturity, regardless of the price. This means it’s possible that an investor will be forced to receive a price that’s well below face value.
The risks don’t end there. You also have to consider the tax factor. Since structured notes are deemed payment of debt instruments, investors will be responsible for paying annual taxes on them, even though the note hasn’t reached maturity and they are not receiving any cash. On top of that, when sold, they will be treated as ordinary income, not a capital gain (or loss).
Pulling Back the Curtain
What if you 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 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 almost too good to be true, which of course, it is.
A good example is a BREN linked to the MSCI Emerging Markets Price Index. This particular security is an 18-month note offering 200% leverage on the upside, a 10% buffer on the downside and caps on 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 from December 1988 to 2009.
Figure 1: MSCI Emerging Markets 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% drop 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.
Remember that the note is based on the MSCI Emerging Markets Price Index, which excludes the dividends. If you were investing directly in the MSCI Emerging Markets Index via a mutual fund or ETF, you would be reinvesting those dividends over the 18 months. This is a huge 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 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%, the MSCI Emerging Price Index was -38.6%, and the structured note therefore was -28.6%. So for these 18 months, the 10% buffer was only worth 7.8% (36.4% - 28.6%), compared to just investing directly in the index.
The Bottom Line
Structured notes are complicated and are not always designed to be in the best interests of the average individual investor. The risk/reward ratio is simply poor. The illustrations and examples provided by investment banks always highlight and exaggerate the best features, while downplaying the limitations and disadvantages. The truth is that on a historical basis, the downside protection of these notes is limited, and at the same time, the upside potential is capped. Now add the fact that there are no dividends to help ease the pain of a decline.
If you choose structured notes anyway, be sure to investigate fees and costs, estimated value, maturity, whether or not there is a call feature, the payoff structure, tax implications and the credit worthiness of the issuer.