A Note on Structured Notes

What happens to all the investments we say no to?  We are acutely aware of how our invested money performs, but it can be difficult to keep track of the investments that just didn’t make the cut.  Did we dodge a bullet?  Or did we miss out on a shooting star?

Structured Notes

I recently came across an email from a year ago where I researched a structured note for one of our advisors.  In the SEC’s investor bulletin regarding structured notes, these are “securities issued by financial institutions whose returns are based on, among other things, equity indexes, a single equity security, a basket of equity securities, interest rates, commodities, and/or foreign currencies.”  I suggest you read the entire thing as well as FINRA’s investor alert on structured notes.

The Pitch

This particular note was pitched to one of our clients by his banker and the client wanted us to tell him whether it was a good deal or not.  The note was presented as giving the client the opportunity to earn triple the S&P 500’s return over the next 12 months, capped at a little over 17% (an amount that seemed astronomical in the midst of the worst start to a calendar year in the stock market’s history).  While some structured notes offer varying amounts of downside protection, this note provided none – the client would fully participate if the market continued to drop.

After some basic due diligence, we advised the client not to get sold this particular structured note.  I say ‘get sold’ because nobody actually buys these things, they are sold by salesmen.  In my experience, the more steps between the underlying investment and the investor, the worse the deal.  This was a note created by one investment bank and was sold by a different investment bank.  Calculating the note’s return was convoluted and capped.  The fees surrounding the note were vague at best.  We pinned down that the selling agent (the banker) got a 1% “placement fee”.  Other fees were explained as being “baked in” to the formula used to calculate the client’s return, but an actual number was never produced.  Illiquidity and unfavorable taxation soured us on this investment product further.  At over 250 pages, the disclosure documentation was longer than the classic novel “Lord of the Flies”.

What if our client ignored these warning signs, though?

From the pricing date to maturity, the S&P 500 returned over 24%!  That’s the total return for the index including dividends, but reading the fine print, the note uses the index level without dividends.  Without dividends, the S&P 500 was up over 21%.  More fine print: the note doesn’t calculate return based on the ending index level, but the average of the last 5 days of the holding period.  Without dividends, the S&P 500’s increase over the average of the last 5 days of that year was over 20%.  Then remember:  the note caps returns at just over 17%.

In exchange for an illiquid security the client could only sell at unfavorable terms before maturity, they would have had the privilege of trailing the S&P 500 by 7%.  How do you earn three times the S&P 500’s return and underperform it at the same time?

Was this a case of bad timing?  Can these notes all be that bad?  I looked at 12 other structured notes we had been pitched over the last 8 years and found similar outcomes.  10 out of 12 notes involving large cap stock indexes would have been losers for the client.  Not all structured notes have bad outcomes, but the illiquidity, opaque price, fuzzy math, and extensive disclosures act as roadblocks to the investor.  It sounds like whoever is underwriting these notes is very good at making money for their employer.  The notes keep getting made so someone is very good at selling these notes as well.  Hopefully investors become very good at saying no to these people.