Structured Notes Can Be Shot In The Dark

(Dow Jones)--Structured notes offer investors the chance to make elaborate bets on the stock and bond markets. But anyone trying to gauge the odds of winning won't get much help from the funds' marketing materials.

The notes, which are typically sold to wealthy individuals through financial advisors or private banks, are big business, attracting roughly $50 billion last year. They typically package options or other derivatives to create strategies for investors who can't or don't want to trade these instruments on their own.

At the same time, however, they usually offer little in terms of guidance about probabilities or historical outcomes for those who aren't already experts in those areas.

Issuers say the notes' unique terms make it difficult to provide additional information, a situation they are working to improve. But some critics take a more cynical view, arguing that notes are designed to look more attractive than they really are, not unlike carnival games where players try to toss rings around milk jugs or puncture balloons with darts.

"It sounds like a free lunch," says David Hulstrom, a Woodstock, Ga., financial advisor who has published research on several structured note strategies that suggests investors rarely come out ahead. "They prey on our mental short cuts."

Many popular investment vehicles, such as mutual funds and exchange-traded funds, typically publish detailed historical data, such as three-, five- and 10-year returns, aiming to convince investors their strategy has worked in the past. When funds are new, issuers often produce so-called "back tests" that show how they might have performed in various historical scenarios. While critics frequently charge that back tests can be manipulated, performance numbers are also vetted by independent watchdogs like Morningstar Inc.

When it comes to structured notes, investors have much less to go on. One typical example: A recent note marketed by Bank of America's Merrill Lynch that is designed for investors who think the stock market will post just modest gains in coming months. The note promises investors a 17.4% return if the level of the S&P 500 is flat or up as much as 17.4% over the next two years. At the same time, if the benchmark falls, or rises by a greater amount, investors receive market returns. In exchange for this benefit, they give up dividends and take the risk that the issuer, Bank of America, won't be able to pay them back.

Investors hoping to figure out how often this kind of bet has worked out in the past have to do the research on their own. The best indication provided by the note's term sheet, a marketing document filed with the Securities and Exchange Commission, is a graph showing the squiggly ups and downs of the Standard & Poor's 500 between January 2005 and December 2010.

There are a number of problems providing investors more in-depth returns, says Liam O'Neil, head of market-linked solutions at Merrill Lynch. One key factor is the sheer number of notes created each year, with big issuers selling a dozen or more per month. While versions of some popular strategies are used again and again, no two notes are exactly alike. Moreover, investors typically buy notes when they are issued and hold them until maturity, so the notes don't yet have a "track record" like a mutual fund when they are sold.

Still, Merrill hopes to expand the type of information it provides, eventually publishing outcomes of all the notes Merrill has issued. "We want to demonstrate the performance makes these investments worth owning," says O'Neil. "We have a good story to tell."

Among Merrill's rivals, Morgan Stanley Smith Barney and Wells Fargo Advisors say they provide information about notes to their own brokers and clients. Other efforts are also being made to help investors independently evaluate notes. At least one company, U.K.-based Future Value Consultants, has been compiling a database of structured-note returns and others that it hopes to sell as part of a subscription service to advisers later this year.