I live in Botswana, should I be Investing in Structured notes?
To the ordinary investor, structured notes seem to make sense. However there are many pitfalls.
Investment banks advertise structured notes as the ideal vehicle to help you benefit from stock market performance while simultaneously protecting you from market falls.
Why Structured Notes Might Not Be Right for You
Structured Notes appear to give upside potential with downside protection. However, investment banks (which are in many ways just sales and marketing machines dedicated to separating you from your money) don't reveal that the cost of that protection usually outweighs the benefits.
But that’s not the only investment risk you’re taking on with structured notes. Let's take a closer look at these investments.
KEY TAKEAWAYS
Investment banks issue structured notes, which are debt obligations with an embedded derivative component.
The value of the derivative is derived from an underlying asset or group of assets, also known as a benchmark.
Investment banks claim structured notes offer asset diversification, the ability to benefit from stock market performance, and downside protection.
A major disadvantage of structured notes is that the investor must undertake significant credit risk in the event the issuing investment bank forfeits its obligations, (as was the case with the collapse of Lehman Brothers in 2008)
Call risk, lack of liquidity, and inaccurate pricing are other disadvantages of structured notes.
Investors miss out on dividends.
What Is a Structured Note?
A structured note is a debt obligation—basically like an IOU from the issuing bank—with an embedded derivative component. In other words, it invests in assets via derivative instruments.
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.
What Are the Advantages of Structured Notes?
Diversification?
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.
Indeed, with many notes downside linked to performance of the worst asset - this can be the opposite of diversification - risk concentration in the worst performer.
Exclusivity
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 collective investments - mutual funds, exchange-traded funds (ETFs) and more.
Besides that, do you think investing in a complex package of derivatives (structured notes) is considered easy to access?
Customisation
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. 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.
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?
Dividends Missed
Remember that, whether a note is based on an Index or a Stock, this price excludes the dividends. If you were investing directly in an Index via a mutual fund or ETF, you would be reinvesting the dividends received.
This is a huge deal that is mostly overlooked by retail investors and barely mentioned by the investment banks.
Credit Risk
If you invest in a structured note, then you have the intention of holding it to maturity. That sounds good in theory, but did you research the creditworthiness of the note's issuer? As with any IOU, loan, or other types 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 2008 during the collapse of Lehman Brothers' structured notes. 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 to the original issuer and that original issuer will know you’re in a bind.
Should you need to sell your structured note before maturity, it's unlikely the original issuer will give you a good price—assuming they are willing or interested in making you 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.
As far as price goes, you will likely overpay for a structured note, which relates to the issuer's costs for selling, structuring, and hedging.
And of course the up-front commission paid to the investment salesperson.
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 creditworthiness of the issuer.