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Expert Perspective

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Investment e.Perspective

Current Issue | July 26, 2018

Too Good To Be True: Pulling Back the Curtain on Structured Notes

By: Daniel J. Ford, CFA, CAIA, PRM, Senior Investment Strategist & Oxford Investment Fellow


"Never let a good crisis go to waste" – Sir Winston Churchill

Financial innovation has provided immeasurable societal benefits regardless of what the mainstream media tells us. Financial innovation has greased the gears of capitalism by reducing structural inefficiencies, increasing borrowers’ access to willing lenders and enabling rational market participants to more efficiently manage risk.

Major financial institutions appear to have heeded Churchill’s advice by ramping up the marketing of equity-linked structured products following the Global Financial Crisis of 2008. Brilliantly devised structured notes promising principal protection and upside participation have proven to be a hit with emotionally-scarred retail investors. These investors place a high premium on principal protection, and brokerage firms are more than happy to engineer away the risk of capital loss. For their troubles brokerage firms receive yet another highly profitable, and opaque, revenue stream for their shareholders.

Principal Protected Notes
One of the most popular structured products marketed to retail investors is the principal protected note. Issuers promise buyers of these securities the guaranteed return of principal at maturity and any positive performance of the underlying index up to a capped level. The note appears as an unsecured liability on the issuing firm’s balance sheet, and the issuer hedges their obligation by bundling, or “structuring” a number of financial products to create the desired economic exposure. For the more financially inclined, the component products used to hedge a principal protected note are typically a zero-coupon treasury strip with a maturity corresponding to the structured note paired with a call spread of equity index options.

The principal protected note appears to be another shining example of financial engineering mitigating unwanted risks and improving portfolio efficiency. Upside exposure to the market, no principal at risk and no annual fees. What’s not to like?

While principal protected notes do appear to offer investors attractive structural enhancements, astute investors should ask themselves “at what cost?”. A number of relevant items to consider when evaluating structured notes include:

  • Explicit Fees: Structured notes typically pay fees through a new issue discount analogous to the front-end load fee usually associated with overpriced mutual funds. Explicit fees typically range from 2% to 10% of the total investment with 1%-3% often being used to pay broker commissions.
  • Implicit Fees: Issuers often generate significant undisclosed fees from the sale of structured notes. This additional revenue stream results from the quoted price to investors materially exceeding the sum-of-the-parts cost for the issuer to create the underlying economic exposure. The difference in quoted price and cost is estimated to be nearly 8% per year on average.1
  • Tax Implications: The IRS taxes profits from structured notes as ordinary income making a passive investment in an index fund significantly more tax efficient. Additionally, the use of component zero-coupon treasury securities results in negative cash flows over the life of the note for taxable investors.
  • Lack of Dividends: Investors in structured notes do not receive the dividends associated with the underlying index due to the use of derivative products to create the underlying exposure. This difference is meaningful as dividends have accounted for 56% of the S&P 500 Index’s total return over the past century.2
  • Issuer Credit Risk: While the return on structured notes is based on the performance of the underling exposure, the payment of any amount due on the notes is nothing more than a liability of the issuer. From a legal standpoint, structured notes are unsecured obligations of the issuing brokerage firm. This presents meaningful additional risk to structured note investors to which they receive no additional compensation. One wonders, would you knowingly make an interest-free loan to your broker? How about paying them for the privilege of doing so? I didn’t think so. This often-overlooked technicality was painfully felt by “principal protected” note buyers from once venerable issuers such as Lehman Brothers in the financial crisis.
  • Illiquidity: With the exception of ETNs, structured notes are illiquid and meant to be held until maturity. The secondary market for structured notes is limited with the only viable liquidity option typically being a sale back to the issuing broker. Issuers are not legally obligated to buy back these securities, and as such tend to extract their pound of flesh from investors hoping to retire their notes early. Additionally, because structured notes are often constructed with a deeply discounted zero-coupon treasury to ensure principal protection, investors will realize a capital loss on their “principal protected” notes when selling prior to maturity.
  • Opportunity Cost: Perhaps the most expensive cost associated with structured notes has been that of missed opportunity. Trading upside potential for downside protection has proven ill-advised, particularly with longer investment horizons. To put that statement into context, the S&P 500 has produced a negative rolling 8-year return in just 1.4% of quarterly periods since 1945. Over this same period, owners of 8-year maturity notes with a 90% performance cap have seen their gains capped a staggering 51% of rolling 8 year periods.

When stepping back and rationally evaluating structured wealth management products, are the protections provided worth the considerations and conflicts? Can you be certain that the issuer will even be able to make good on their “guarantee” in a truly draconian market environment? History and basic statistics suggest the answer to these questions is “no”.

So why then are structured notes so popular? We suspect investors are naturally drawn to the promises of principal protected notes due to behavioral biases such as loss aversion, recency bias and the tendency to assign irrationally high probabilities to unlikely events. Brokerage firms are acutely aware of these behavioral biases, and thus frame their marketing pitches to exploit our psychological deficiencies. By focusing on the attractive features structured notes provide, issuers are able to lure investors without ever divulging the exceptionally high implicit costs of those protections.

The Father of Modern Portfolio Theory, Harry Markowitz, is often quoted as saying that “diversification is the only free lunch in finance”. Objective fundamental and quantitative analysis allows us to conclude the Nobel Laureate’s words still ring true. We believe that pairing lowly-correlated niche strategies with reasonably priced passive exposures is still the most reliable way to mitigate risk and grow wealth over the long term.

While we are generally supportive of financial innovation, we have yet to find a well-constructed, conflict-free structured note suitable for retail investors. As with most things in life, if something appears too good to be true, it usually is.

1J. Henderson & N. D. Person (2011). ‘The Dark Side of Financial Innovation’. Journal of Financial Economics
2 Oxford Investment Fellows using data provided by Robert Shiller. http://www.econ.yale.edu/~shiller/data.htm.

The above commentary represents the opinions of the author as of 4.19.18 and are subject to change at any time due to market or economic conditions or other factors.