Introduction
Recently, an article by Benjamin Felix titled “Ask an adviser: Structured notes are designed to exploit cognitive and emotional investor biases” raised concerns about the nature of structured notes. While it is essential to critically evaluate investment products, it is equally important to address misconceptions and provide a balanced perspective. In this article, we aim to clarify some of the errors and misconceptions presented in Felix’s piece, highlighting the potential benefits and considerations associated with structured notes.
Objective of Structured Notes
Felix suggests that structured notes primarily serve as a means for financial institutions to raise capital, emphasizing their derivative component. While it is true that structured notes are debt obligations, their primary objective is to offer investors exposure to underlying assets while providing certain risk management features. They are designed to cater to different investment needs, including downside protection and limited upside participation.
If a bank wants to raise capital they have easier ways. Issuing traditional bonds have much less legal and operation burden and usually attracts more investors. There’s a benefit to raising capital using structured notes, especially as structured products holders usually hold the product until maturity, improving the diversification of their funding. Nonetheless, structured notes represent in average less than 4% of global funding.
Investor Biases and Exploitation
Felix argues that structured notes exploit cognitive and emotional investor biases. However, it is important to recognize that any investment product, including traditional stocks and bonds, or even actively managed solutions can be subject to such biases. I would argue that most investment products use past performance as an indicator for future performance, but we all know that the past performance of a product does not guarantee its future.
Structured notes do take into account that investors are risk averse. That means that investors feel losses much worse compared to the same positive gain. So, having an investment that provides a potential return but have less risk on a negative performance looks much more attractive to investors. But is that exploiting investors or giving them what they want?
The responsibility lies with financial advisors and investors to thoroughly understand the features and risks of any investment and make informed decisions. Structured notes can provide a valuable tool for portfolio diversification and risk management when used appropriately.
Downside Protection and Upside Participation
Felix suggests that downside protection features in structured notes may lead investors to overvalue them, while limited upside participation could be costlier. However, it is essential to consider individual investor goals and risk tolerance. Structured notes offer a spectrum of risk-reward profiles, and investors have the flexibility to choose products that align with their specific investment objectives. The trade-off between potential returns and downside protection is a decision that should be carefully evaluated based on personal circumstances.
Inflation and Dividend Considerations
Felix highlights concerns about nominal principal protection and missing out on dividends with structured notes. While it is true that investors should consider the impact of inflation, it is important to note that structured notes can provide a better return/participation as banks discount estimate future dividends from the optionality embedded on structured notes. There are also some structured notes that incorporate dividends, such as synthetic dividend indices, and investors should review the terms and features of specific products to fully understand their implications.
Complexity and Performance Evaluation
Felix suggests that the complexity of structured notes allows financial institutions to exploit unsophisticated investors. However, complexity does not automatically imply exploitation. While structured notes may require a deeper understanding than traditional investments, this complexity arises from the need to tailor products to specific investor preferences and risk profiles. Rigorous due diligence and thorough comprehension of the terms and features can mitigate potential risks and enhance the investment decision-making process.
The value for money of structured products
Structured products are often difficult to analyse as they do not have a normal distribution of returns due to their unique payoff profile and bespoke nature. In this study, we addressed this challenge by examining the daily indicative price from issuers as well as all the coupons paid during the life of the products, which helped to solve the problem of the returns distribution.
To further analyse structured products, we categorized them into three types: capital protected, growth, and income. By doing so, we were able to group together products with similar levels of risk and create indices for each category to analyse their value. We used the indicative prices of 17 issuers of products distributed in the US market between July 2020 and November 2022 to calculate the indices. Any product that had at least 100% capital guaranteed, we categorise those as capital protected products, while we split the remaining products as Income if they had regular payments (fixed or contingent), while the remaining products were considered growth.
There are some limitations and potential biases in this approach. For example, the categorization of products is subjective and may not fully capture the complexity of each product. The researchers also relied on indicative prices provided by issuers, which may not accurately reflect the market value of the products. Additionally, the analysis was limited to products distributed in the US market between a specific period, and therefore the results may not generalise to other markets or time periods.
Product and daily performance analysis in the US
Even while comparing the figures of just 2.5 years, the data shows very interesting results. Specially as 2021 was a rally year for the S&P500 followed by a bear market in 2022, with a recent recovery. Looking at a high level, S&P 500 was the best performance, with 30% return in this period, against 11.69% of growth structured products, followed by 4.61% return of Income structured products and a negative performance of 4.85% of capital protected products.
Three indices that measure the performance of structured products are the Growth SPs, Income SPs, and Capital Protected SPs. Between 2nd July 2020 and 2nd November 2022, the S&P 500 index outperformed the other three indices, delivering a return of 30.35%, while the Capital Protected SPs index recorded a negative return of -4.85%, indicating a decline in the value of the underlying assets. The volatility of the Growth SPs index was 5.36%, the Income SPs index was 3.78%, and the Capital Protected SPs index was 2.00%. The Sharpe ratio, which measures risk-adjusted returns, was the highest for the Growth SPs index at 2.18, followed by the S&P 500 index at 1.31.
Performance of structured notes in Canada
In Canada, structured products have demonstrated a consistent performance over the past four years. From 2020 to 2023 YTD, the average annualized return of structured products remained steady, ranging from 7.03% in 2023 YTD to 8.25% in 2021. Despite the uncertainties and market fluctuations experienced during this period, structured products have delivered positive returns, with an overall average annualized return of 7.92%. These figures indicate the potential for structured products to provide attractive returns to investors in Canada, contributing to their appeal as investment options within diversified portfolios.
Conclusion
Structured notes, like any investment product, have their own characteristics, benefits, and considerations. It is important to approach these products with a critical mindset, conducting thorough research and seeking advice from qualified professionals. While the concerns raised in Benjamin Felix’s article are valid, it is essential to acknowledge the potential advantages and the role structured notes can play in achieving investment objectives. Investors should carefully evaluate their risk appetite and consider structured notes as part of a diversified investment strategy.
Disclaimer: This article does not constitute financial advice. Investors should conduct their own research and consult with financial professionals before making any investment decisions.
