May 19, 2016 | by James Behr Jr & Christopher Paleologus
We have invested in Structured Investments through bull, bear and flat markets and continue to recommend them because of their ability to provide both partial downside protection and upside potential.
What is a Structured Investment?
First, it is important to remember that the term Structured Investment/Product/Note is just that – a generic moniker used to describe a bank issued note that uses derivatives to create the desired exposure to one or more investments. Essentially they are notes that pay returns based on an index meeting certain criteria. Structured Investments vary greatly from note to note, and just because something is considered a Structured Investment does not make it suitable. In fact, we would generally recommend that most investors stay away from many notes as most tend to be overly complex. When we allocate new issue Structured Investments to our clients’ accounts, we develop the terms of the notes ourselves. These terms are then bid out in a competitive process whereby we are trying to achieve the best possible terms under current market conditions.
To understand the Structured Investments that we invest in for our clients, let’s take a closer look at the terms associated with these investments.
• Maturity: Usually 13 to 18 months, so any gains are taxed as a long-term capital item. We typically do not request terms longer than 18 months because the full benefit of the Structured Investment is not realized until maturity.
• Underlying Index: The returns are calculated by the performance of an underlying index, which is usually the S&P 500, Russell 2000, or the EuroStoxx 50.
• Downside Protection: Structured Investments offer partial downside protection against declines in the market (underlying index). Typically our notes have a 10% buffer. If the underlying index were to fall from the inception of the note until maturity, the notes would not participate in the first 10% of the decline. For declines greater than 10%, the losses would be one to one. In other words, if at maturity the underlying index declines by 15%, the note would lose 5%.
• Upside: The potential profit of the note is tied to the return of the underlying index and typically provides a multiplied return of 1.5x or 2x the index. For example, if the note provides 1.5x return on the index and the underlying index has gained 5% at maturity the note would return 7.5%.
• Maximum Return: Thus far, tax efficient investing in familiar indexes with multiplied returns and downside protection, probably sounds too good to be true and it should. One of the negatives to the Structured Investments described above is that there is a maximum potential profit. For example, if the maximum return is 10% and the underlying index is up 15%, the return on the investment would be limited to 10%. The maximum return differs from issuer to issuer, and is affected by a multitude of factors including interest rates and market volatility.
Often times, the Structured Investments offered to investors are created by the bank or brokerage firm where the accounts are held. There is no competition in order to gain the most beneficial terms and the terms of the notes may be complex and quite confusing. One advantage that we offer is that we convey the terms that we are seeking to multiple issuers and then compare the maximum returns to help us choose which would be best for our clients. The banks are aware that we are going to several different issuers and understand that in order to win our business they must provide competitive terms. This is another benefit of us being an independent Registered Investment Advisor as we are free to choose the provider that is best for our clients, not the provider which is best for the bank and/or brokerage where the accounts are maintained.
Below are the terms of a note that was issued on February 24, 2015 that matured last week.
Issuer: JPMorgan Upside multiplier: 1.5x
Issue Price/Par value: $100 Max return: 12.10%
Index: Russell 2000 Maturity: May 11, 2016
The above exhibit illustrates the original terms of the investment and the subsequent payoff of the note in relation to the Russell 2000 return. The yellow box represents the return of the Russell 2000 (May 11, 2016), which is down 9.66% since inception. When the investment matured, the total gain on the note would be 0% (full return of principal) as a result of the 10% downside buffer, obviously not a great return, but much better than losing the 9.66% that the Russell 2000 declined.
In most cases for our clients when a Structured Investment matures the funds are then reinvested into a new structured note to keep the client invested and the ladder intact, similar to that of a bond portfolio. When this note matured we reinvested the funds into a similar note with the terms and payout scenarios described below:
Issuer: Goldman Sachs Upside multiplier: 1.5x
Issue Price/Par value: $100 Max return: 11.70%
Index: Russell 2000 Maturity: July 13, 2017
This note was issued on the same index but we increased the downside buffer level to 15%, which means that if the Russell 2000 is down 15% at maturity you would receive your full principal amount back. You can see that for the added downside protection we have given up some upside potential. If the Russell 2000 were to increase 20% over the given time period this structured note would be up only 11.70%.
One of the main points we like to stress to our clients is that if you had invested $100,000 in just the Russell 2000 index over the same time period you would have lost $9,660 leaving you with only $90,340 on May 11, 2016. If you had invested the same amount in the first structured note you would have received full return of your $100,000 principal on May 11, 2016.
The benefits become even more apparent when we look at what happens to our ending values if they are reinvested back into another structured investment or left invested in the Russell 2000. You can see that the Russell 2000 would have to go up 10.69% to just get back to your original investment.
Taking it a step further, while we may have limited our upside to 11.70% for the added downside protection, the Russell 2000 index investor would still need the index to increase 23.64% just to our value of $111,700. So that’s 10.69% just to get back to even and 23.64% to yield our maximum return. The buffered note investor would only need the Russell 2000 to increase 7.8% to obtain our maximum gain of 11.70% because of the 1.5x return on the index.