Structured notes are booming, with sales reaching $45 billion just this year. Despite their growth, structured notes can be a risky venture for investors, especially as more and more brokerages push out structured products with the promise of equity returns and less risk.
As reported Nov. 13 by the Wall Street Journal, some financial advisors are urging their clients to consider structured notes as a way to get back into stocks and avoid taking on too much risk.
Before jumping on the structured notes bandwagon, however, investors need to first consider a few issues. To begin, most of today’s structured notes are not 100% “principle protected” products. Instead, they typically offer only partial or limited protection, meaning they provide a fixed amount of contingent protection. Losses are covered only up until the point that the underlying asset drops below a certain level. Once that happens, the protection is canceled and investors bear the brunt of the losses.
Consider UBS AG’s Return Optimization Securities with Contingent Protection, which was priced in July. According to the Wall Street Journal article, investors receive 100% principal protection as long as the Standard & Poor’s 500-stock index hasn’t fallen more than 30% at the end of the product’s three-year term. If the index does fall more than 30%, investors pay the price by suffering all of the losses. If the markets fall by less than 30%, investors get back their principal at the end of product’s term. If the index rises, investors earn 1.5 times the upside, up to a cap of 58.6%, which they get if the index is up 39%. Fees, also called the “underwriting discount,” are 2.5%, says the WSJ.
The kind of protection might not work for all investors. As reported in the Wall Street Journal article, since 1926, a structured note that protected against a drop of 30% in the S&P 500 would have pierced the downside cap 7% of the time, leaving the investor exposed to the entire loss, while protecting them from a loss 17% of the time on a rolling 36-month basis.
Craig McCann of Securities Litigation & Consulting Group is skeptical of structured products. According to McCann, the vast majority of structured products turn out to be worth substantially less than their face value. Moreover, structured notes can be difficult to sell during a market rout. Investors also have to worry about counterparty risk.