“Participation in risky assets with limited downside”? Sign me up!
This is the kind of pitch I have been seeing for structured notes: investment products with predefined returns linked to some underlying asset such as an index or a basket of stocks.
Downside protection and upside participation can be enticing, but in my opinion, structured notes are complex contracts designed to exploit cognitive and emotional investor biases.
Structured notes are a way for financial institutions to raise capital: They are senior unsecured debt obligations of the financial institution that issues them. Unlike more conventional securities such as bonds, structured-note payoffs have a derivative component linked to an underlying risky asset.
They will typically have some level of downside protection, and a limit on upside participation, based on a payoff formula linked to the underlying asset. The fact that these products cater to investor biases is why they can be problematic, particularly for retail investors.
Structured notes will tend to pay off more in states of the world that investors overweight, and less in states that they underweight, leading investors to overvalue certain features of the notes. Specifically, investors tend to think that the next big market crash is just around the corner despite the fact that these extreme events are infrequent. This leads investors to overvalue downside protection features. However, the limited upside participation in structured notes will tend to be far more costly to investors than protection from rare disasters.
Furthering the illusion of safety, when people imagine losing money, they typically think in nominal terms – that is, not adjusted for inflation. This is referred to as the “money illusion” and it causes investors to see the type of nominal principal protection that many structured notes feature as risk-free, when in reality they may lose purchasing power over the term of a note.
Additionally, structured notes are typically linked to price-only indexes, meaning that investors in the note participate in the price returns of the index, but leave dividends on the table. Dividends have historically made up a meaningful portion of total returns and missing out on them materially increases the chance of losing purchasing power in the long run. When investors fail to realize that their structured note delivers a price-only return, it is referred to as the “index illusion.”
One of the ways that structured notes are marketed to investors is through high “headline rates,” the best-case return or yield scenario, which may not be representative of the expected total return of the product. This poses a further challenge in assessing the products.
An investor may reasonably miss these points. It can be difficult to assess structured notes since they are significantly more complex than something like a plain vanilla index fund. Complexity is one way that financial institutions can exploit unsophisticated investors to increase their profit margins.
Academic research on structured notes overwhelmingly suggests that they are typically overpriced, often by 5 per cent or more, and that they typically underperform simple alternative allocations to stocks and bonds.
Like any strategy with option-like payoffs, evaluating structured products with traditional performance evaluation metrics such as their average return and the standard deviation of their return will make them appear far more attractive than they are.
If the financial institution issuing a structured note can sell them to investors at a higher price point than it costs to hedge their exposure to the payoffs, they are effectively getting access to cheap capital. Investors need to be aware of this incentive structure when they purchase structured notes.
Structured notes will additionally often, but not always, pay commissions to the financial advisers selling them. This creates another challenge for retail investors who are receiving advice from a commission-motivated financial adviser.
To quote economist John Cochrane: “When having dinner with lions, make sure you are at the table, not on the menu.” When it comes to such complex products as structured notes, retail investors are often the tastiest item on the menu. To avoid being eaten alive, they should typically avoid these products.
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Benjamin Felix is a portfolio manager and head of research at PWL Capital. He co-hosts the Rational Reminder podcast and has a YouTube channel. He is a CFP® professional and a CFA® charterholder.
