Designed to deceive: structured notes

Their high costs transfer return to the issuer and costs to the investor, skewing the risk/reward profile of investment outcomes; they also complicate the management of the portfolio by taking away liquidity and yield and ultimately return, forcing the portfolio itself to awkwardly adjust for their absence.  Most of those who recommend complex products on a regular basis have little respect for the portfolio and little fundamental construction knowledge.  The structure and the marketing of these products is designed to deceive.

I recently had a structured note placed under my nose for comment: a 3 year auto callable structure.  I really do not know how investors are meant to understand how these work and you really do need to understand how risk is priced to appreciate what it is you are buying and paying for.

When you own an investment, whatever your intellectual framework, you understand that the return you are expected to receive is an average of all the ups and downs and the certainty of expected return is uncertain over short time frames. 

If we were to just focus on the ups we would get an unbalanced view of the investment’s return and its risk.   But that is just what many investors are being asked to do when they buy some of these sophisticated structured notes. 

Hedging risks and leveraging returns via options and futures and complex products requires a sophisticated knowledge base.  Unless you are an intermediary, earning a return from transaction spreads and who need to hedge out the risk of the assets, hedging should really only be judicious and sparing. 

When someone takes on your risk and accepts a premium for that transfer, they expect on average to retain that premium.  Most of the time it is in reality a transfer of return.

At the moment, a put option on the S&P 500 would cost about 7.8% (for a circa 1 year option – Dec 2014) if you were looking to cover declines from current levels and this is with historically low implied volatility in the market.  

If the market was perfectly priced and efficient (and a few other assumptions!) we might say that the expected downside risk of the index for a mean return of say 7% and a standard deviation of some 15.5% would be about -3.4% (that is the sum of -ve returns x their probabilities).  The probability of a decline greater than 7.8% would be circa 16%.  If you believe a market is over valued or volatility is likely to increase, the probabilities are going to be different, but you get my drift – most of the time you are expected to lose the return.

If you purchase a direct option you are at least aware of the cost and the hurdle rates.  This is not the case with structured products.  

Structured notes are more complex beasts.  The 3 year callable I was looking at emphasised the outsize returns available for small +ve changes in an underlying reference investment/index over a small part of the potential distribution of returns.  But, in point of fact a whole range of outcomes are possible that are not effectively captured in the material.      

Some key points

  • Prominence was placed on the product’s highest yielding portion of the return spectrum – in this case the 9% return on the benchmark that would be received if the index ended the year at 0% change or above.  This ignores a) the full spectrum of return which usually underpins most expected return calculations and b) that it focuses the investor’s mind on the simplicity of beating a current price when in fact the price a year from now is much more tentative.  It gives the illusion of being a safe and rewarding bet.
  • Marketing material ignored the benchmark return or rather the hurdle rate of return the investment would need to beat to justify its existence.  These are “prescribed debt obligations”, and hence are technically fixed interest investments.  In the issue I was looking at the capital would constitute “unsecured, unsubordinated debt” with funds raised added to the issuing bank’s “general funds”.   The hurdle rate is therefore a similar corporate bond rate for the issuer in question.  Note that it would appear the issuer is using the product to borrow money.   If you are properly comparing hurdle rates though you would need to adjust the bond yield up to account for that part of the distribution which would not be paid in the event of the index falling below zero. 
  • There are implicit costs in these products that are not mentioned or explained.  If the issuer was using digital options to structure the payoffs, the costs of these options should really be made known to the investor to help them understand the product.  On the other hand, if the issuer is writing the options, then how are they pricing these options? In fact I was unable to find information in the offering document as to how the products would actually be managing/hedging risk
  • We also have the commission and other fees (of around 2.25% + 0.2%), but these cannot possibly cover all the costs/benefits of the product.   For one we do not know whether the assumptions used in the pricing models are fair or what other costs are covered in the pricing.  Associated transaction costs are also not covered in the decision process – many of these products are short term in nature and capital released on maturity or on an earlier call will need to be reinvested.   These reinvestment costs need to be factored in when considering the suitability and attractiveness of these investments. 

With regard to the benchmark hurdle, the product is essentially a fixed interest investment with an irregular income payment and the hurdle rate should be that of a bond with a similar profile – unsecured unsubordinated debt obligation.   The term of the bond against which you would benchmarking should really be the term of the security you would otherwise have held in the portfolio or the term of the product whichever is the longer.  So when assessing the return profile of structured notes you should be looking at the net return above/below your benchmark after adjusting for the costs of re-establishing the portfolio. 

The additional relevant risk (over and above the credit risk) is the risk of capital loss should the reference index decline below a certain level.   So you have exchanged, if you are exchanging a bond holding position for the product, a certain return for a lower probability, more uncertain, higher return and a much higher level of downside risk in the event of an outlier risk event.

The note in focus has a range of returns:

  • If the reference index returns anything from 0% upwards the note will be called and the investor will receive a 9% return.  If the index returns more than 9% over the year, the note will pay an additional 10% of any gain. 
  • If the reference index has a negative return, the bond will not be called in any given year until the designated maturity date.  No coupon or interest will be paid during the term of the note unless called prior to maturity or at maturity if the index return is positive.  So if the index fails to provide a 0 or +ve return over the term of the note, no return will be received whatsoever.   In terms of opportunity cost this is a negative of the benchmark bond return.
  • Only if the reference index falls below a % of the starting level by the end of the term (a 25% loss in this case) will the note be exposed to the full capital loss of the reference index.  The risks are very low if you look at straightforward statistical probabilities but they are meaningful during a time frame of significant structural economic risks and high market valuations.

As stated, the trouble with the marketing aids accompanying these products is that they emphasise the 9% return + 10%, but fail to discuss the benchmark hurdle rate or the impact of the full range of probable outcomes that are likely to impact the expected return over the period.  

If we just use a basic model, and look at a one year time frame, and distil the 25% barrier to a compound annual circa 9%, (assuming an annual standard deviation of 15.5%, an expected return of say 7%, a bond hurdle rate of 3.5%, a normal distribution) the actual net expected return of the product, relative to the benchmark, would be a negative circa 0.5% (assuming a normal distribution of risk and return).   But these products do not include dividends, so the expected mean capital return could well be lower.  At 5% mean expected return gross return is about 1.9%, which is probably much less than the expected return on a bank issued corporate bond..

The wider the standard deviation, the lower the expected capital return (average of ups and downs) and the greater the downside risk, the less attractive these investments. 

These products are implicitly dependent on low but positive market returns, with low volatility, on markets being fairly valued and not over valued, on the economic and market cycle being reasonably advanced but not too young or long in the tooth.   They are a bet and they are designed so that on average (and academic research suggests the average is weighted in the issuer’s favour) you risk being on the wrong side of the trade given the costs of the hedge, the costs of the product.  This is likely to be exacerbated by the potential non normal distribution of stock market risk at the present point in time.

Importantly, as stated at the start, they are very difficult to place in a portfolio.   If you have liabilities you would not wish to swap lower risk allocations that may be needed to match these liabilities, as you remain exposed to a risk event.  Likewise, if you have tight financial demands on the portfolio you would not want to transfer allocations from income producing assets, as this would create a necessary reallocation of other assets within the portfolio.  Essentially these investments have greater relevance for individuals with minimal near term income and capital needs  and a positive view on the returns needed to justify the risks being taken. 

Further reading & references

One thought on “Designed to deceive: structured notes

  1. As I said to Ken Kivenko, it is extremely difficult to heap base vitriol on such a complex topic. I think overseas there is a lot more focus on these products. Canada’s regulators are behind the curve on these investments, as were most regulators, but they at least are trying to catch up. Too little understanding of the fundamentals of portfolio structure and people turning a blind eye to the consequences of these stand alone complex investments. I am not against the use of derivatives and do think there is a place within portfolio structure to integrate hedging, but what we have at the moment are very awkward, clunky solutions. Betting on market movements to generate outside returns within narrow bands is difficult to place in any suitability spectrum.

    Thanks for your comment.

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