Posted on: 20-09-2016 in Investments
Here at Holborn Assets, over the years we have witnessed a lot of controversy in the personal finance industry about a financial product known as a “Structured Note.” Whether a private individual gets involved with Structured Notes is a matter for them to decide with their IFA. Certainly, Structured Notes have got a thoroughly bad name nowadays. Respected website Investopedia.com doesn’t mince words in branding them “a real stinker of a product.” However, there’s a certain glamour to Structured Notes too, because they allow normal people to access “derivatives”. So what is there to watch out for?
On the face of it, Structured Notes offer the best of both worlds. A Structured Note allows the purchaser to benefit when the markets move up AND simultaneously be protected when the markets move down; upside exposure and a downside buffer. On top of that attractive prospect comes the added bonus that a Note can be issued in virtually ANY market or combination of markets, so there’s plenty of choice. This dual benefit is attractive but, generally speaking, Structured Notes look better than they are. They are so structurally complicated (being based on an underlying asset AS WELL AS another derivative) that it is often difficult to see how they work, let alone what potential pitfalls they offer. As you’ll know, in the financial world there’s no such thing as a free lunch, but the enticing payoff formulae of Structured Notes can make you a believer — until, that is, you factor in both the caps which stop you benefitting TOO much when the market rises and the exclusion of dividend re-investment that are often involved. And even when those factors don’t apply, there remains a fair amount of risk to be paid for one way or another with other derivatives involved.
A Structured Note is a “derivative”. One simplistic way of describing a “derivative” instrument is to say that it is a financial arrangement based on an underlying reference asset or benchmark. A Structured Note is a dual product. It has not one but two references: one such reference being ANOTHER derivative, the other reference being any of “equity indexes, a single equity security, a basket of equity securities, interest rates, commodities, and/or foreign currencies.” (US Securities and Exchange Commission). A Structured Note is called a “Note” because it is an IOU note from the issuing bank to you. It frames a given agreement that the bank will pay you a return that is directly proportional to the satisfaction of a set of given market-related criteria. That payment will come either in regular intervals during the course of the Note’s duration, or only when it comes to maturity and expires. There are numerous different factors which are used to put Structured Notes together. But, in many cases, how the numbers actually work out for the investor in a particular Structured Note can be laid out in a simple formula of any Note lasting a given duration giving you 1) x% exposure to the upside 2) x% buffer on the downside and 3) a cap of x% on the underlying reference performance. So, supposing the underlying reference is a tracker. As an example of a possible vanilla Structured Note, the bank could offer to pay you 1) 150% of any rise in the tracker 2) protect you from the first 10% of any drop in value and 3) stop paying out when the tracker fund experiences more than a 20% gain. Sounds wonderful. Shame it rarely works out that wonderful.
There are plenty of “structured” products that don’t involve the high-risk derivative basis of Structured Notes. So don’t bother with them apart from in very specific circumstances – that’s our advice. And it’s not just the high risk that’s the problem. The fiercest allegation made against them is that Structured Notes are deliberately complicated to confuse the potential investor, highlighting theoretical potential gains whilst hiding almost inevitable downsides. That allegation takes a fairly dim view of investment banks, that’s for certain! And there are so many different types of Structured Notes that it is unfair to generalise in that regard. But the bottom line remains that investing as part of a wider holistic strategy cannot involve gambling your entire seed fund according to rules that are barely understood. The level of uncertainty intrinsic to Structured Notes as a consumer product makes them a dark horse we can usually do without. ********************** Are you concerned about your financial future? Interested in investing? As your trusted provider of holistic financial solutions, get in touch with Holborn today!