Structured Notes: An Asymmetrical Portfolio Diversifier
A structured note (“SN” or “note”) is a debt obligation that also contains an embedded derivative component that adjusts the security’s risk-return profile.
Generally, in whole or in part, part of the performance of a structured note is dependent on the performance of an underlier – mostly indexes, a combination of indexes, and sometimes individual baskets of stocks. Simplistically, there are two types of notes – income or yield-oriented notes and buffered or growth notes — with lots of variations and enhancements for each type. These generally are features or certain combinations of features that deal with specific risks or enhance returns. For investors that want to be more proactive in managing risk and enhancing returns, the structured note universe provides a sophisticated tool kit for delivering off-the-shelf or customized solutions.
Does the issuer of the structured note matter?
Except under the most extreme circumstances, it really doesn’t — most issuers are large, well-capitalized banks. Maybe I’m being a little cavalier here. Let’s back up. Yes, all things being equal, higher-rated issuers are obviously better. But it’s incremental and on the margin. SN portfolios make up a small portion of their balance sheets and they hedge and manage individual and overall exposures. But terms can vary — sometimes widely – depending on the current exposures of a particular bank and its strategic and tactical priorities. Even specific timing can matter a lot.
Why go through all the brain damage – why not just buy the index?
With downside protection, on a risk-adjusted basis, you can do better than just owning the market and riding the waves, up or down. You can mitigate or potentially eliminate the downside “tail” risk, but you have pay for the protection by giving up some of the upside. Typically, however, investors are happy to make that trade if it increases the likelihood that target hurdle rate returns are met. Essentially, structured notes can “stack the deck” in the investor’s favor.
Let’s take that a step further. What if the expected returns for the index are low? Currently, Research Affiliates says the return from US Large Cap stocks for the next 10 years will be 5.5% nominal (2.2% real) annualized. How can I reach my target returns and or participate in more of the absolute upside, or get a higher coupon? Potentially, by choosing individual stocks as the “underliers” for determining the terms and performance of the notes.
But which stocks and how are they selected? That really matters. What’s the rationale for including certain stocks and excluding others? One approach is to build curated “folios” (small stock baskets) chosen with an investment rationale in a systematic way, utilizing a process that has delivered real alpha in other contexts. Notably, this approach can also provide another layer of downside protection beyond the note’s structure. How? By finding individual stories whose success isn’t completely dependent on macro factors (GDP) or market direction (BETA), investors can lower downside market capture and lower market correlations.
This all sounds great — why does it seem too good to be true? What’s the catch?
There are a few things to know.
First, structured notes are illiquid investments that require a multi-year commitment. While there is a robust secondary market for achieving liquidity before maturity, premature liquidity often comes at a discount.
Second, these are sophisticated products that require some effort to understand and explain. Education through structured note distributors, like InspereX, is recommended and encouraged.
Third, even though each note has its own specific identifier (i.e. CUSIP), including notes in portfolios can pose some operational challenges for certain platforms and for particular custodians that make these investments more complicated to hold.
Finally, unless you are an institutional investor, these products are difficult to access without the assistance of a financial advisor.
In our opinion, for the educated, structured notes can be especially useful in designing specific risk/reward scenarios as part of asymmetrically diversifying an investment portfolio. Check out our recent Growth Investing Podcast to learn more!
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