Advisors give structured notes decidely mixed reviews.
Structured notes are either the greatest thing since
sliced bread, or the worst thing since typhus. It depends on whom you
ask.
A creation of the large investment banks, structured
notes offer a way for individual investors to diversify their
portfolios away from traditional stocks and bonds and invest in more
novel asset classes, like commodities, international equities and real
estate. Their structures vary widely, but most mature in three to five
years, contain principal protection and offer investors a leveraged bet
on markets to which they would not easily have access.
Indeed, interest in the product has grown
significantly over the last several years. Nearly $64 billion in
structured products were issued in 2006, up 33% from the $48 billion
notional amount issued in 2005, according to the Structured Products
Association. Part of the reason is that, like many products originally
geared toward the ultrawealthy, they are now marketed to the wealthy
masses.
"When these things first came out, only the very
wealthy could afford the million-dollar minimums. But now they've
become so commonplace you see deals with $10,000 or $15,000 minimums,
so even smaller players can take advantage," says Leroy Tanker,
president of Atlanta-based Freedom Financial Services and a financial
advisor with Raymond James Financial Services.
Structured notes have three main components: some
type of underlying bond, such as a zero-coupon bond, to provide
principal protection; a customized option, which is structured to carry
upside with limited downside; and the fees that go to the investment
bank that structured it. The notes often have 100% principal protection
and offer investors some participation in the upside of the underlying
security.
Tanker says he recently put some clients in
three-and-a-half-year notes that were based on a basket of commodities,
and investors not only had all of their principal protected but were
able to participate in 140% of the upside. So if the basket of
commodities was up 10% over the three-and-a-half-year period, investors
received 14%, thanks to options that leveraged the investment, Tanker
explains.
But he says the tax consequences of the structure
can be tricky. The notes are billed as having returns that are taxed as
long-term capital gains at a rate of 15%, rather than ordinary income.
But the zero-coupon bond component can accrue interest along the way,
and that is taxed as ordinary income. The result is
that investors could wind up paying a tax rate of 35% on income they
have not even received.
For that reason, some advisors will not buy them for clients with
taxable accounts. They reserve them for those investing in IRAs or
other retirement accounts, Tanker says. "You have to be very watchful
of the tax consequences," he warns.
Structured notes are for people who don't mind risk
and volatility, and yet the product doesn't really have either, says
Matthew Chope, financial advisor with the Center for Financial Planning
Inc. in Southfield, Mich. "You can have 100% principal protection and
invest in something that would otherwise be very risky. That's the big
benefit," Chope says. "It's a way for people to invest in risky
investments without the downside."
Chope explains the product this way: An investment
bank might sell a $100 structured note in which $95 was used to buy a
zero-coupon bond for principal protection and the remaining $5 would be
used to purchase an option. Some products also contain buffers against
losses; a note with a 20% buffer means the underlying asset could fall
20% before the investor takes a hit.
Chope says the product is structured so that it
mitigates the roller coaster ride some investors experience as their
investments are whipsawed by the vagaries of the markets. "People will
knee-jerk pull themselves out of an investment because they're scared
out of their wits," Chope says. "But studies have shown that people who
can manage their emotions are the ones who are most successful and the
most well-off. This kind of product takes some of the emotion out of
the equation."
The downside is that with maturities of three to
five years, the product ties up an investor's money for some time.
Those wanting out are subject to the whims of a secondary market that
lacks liquidity. For that reason, even advisors who like the product
say investors should not allocate more than 25% of their portfolio to
structured notes, and that allocation should be spread among several
deals.
"Done in the right proportion, and filling the right
need, they make sense," says Louis Stanasolovich, president and chief
executive officer of Legend Financial Advisors in Pittsburgh.
But the fees can be high, he says. Some carry hefty
structuring fees of 2% to 3% as well as sales fees ranging from 1.5% to
3%, depending on the product's term. While larger firms like his can
reduce the fee by taking down a larger portion of the deal, the cost is
still high relative to other investments. The structures are also
somewhat complicated to understand, he says. "It took us six phone
calls with these investment bankers to understand these, and I don't
think we're stupid," he says.
The more skeptical advisors wonder whether anyone
really understands the product-outside of the investment banks
structuring them. If they did, they wouldn't be buying them, says
Stephen Barnes, a portfolio manager at Phoenix-based Barnes Investment
Advisory. "I hate these things," Barnes says. "I think they're just
moneymakers for the bankers, and they're oversold."
All the reward without the risk? Right, Barnes says.
"That doesn't happen. These are not products for sophisticated
investors, because frankly, I don't think sophisticated investors would
buy products like this."
The notes can be based on anything, and usually
involve sectors that are hot. About a year ago, it was notes based on
gold. Six to eight months ago, it was deals tied to European equities.
Commodity-related products, which give investors exposure to the
infrastructure buildup in China, India and Brazil, also have been hot
for the last year.
Barnes says the machinery at the brokerage firms
goes into high gear and produces structured notes tied to whichever
sectors are hot. "It's very much flavor of the month. Whatever stocks
are moving, that's what you get calls on," he says. "If they can
promise you a 9% or a 12% coupon, and if you don't read the material,
that sounds almost too good to be true, which of course it is."
Barnes says not only wouldn't he dream of putting
his clients into the product, but he's had to spend a fair amount of
time getting new clients out of them. That's because the structure is
inherently problematic, he says. It shifts the risk/return profile of
the underlying security negatively to the investor. That is, investors
receive less upside from the underlying security than they would
ordinarily receive had they bought the security outright, and yet
the downside exposure remains the same.
Likening it to a covered call, he explains it this
way: Say investors want to buy shares of Newmont Mining Corp. A
structured note deal would give them that exposure, but instead of
their having to wait for the stock to go up, the deal would pay them
some of that upside income up front. But it comes at a cost: The deal
is structured so that they give up some of the upside if the stock
shoots up in price later. And yet because the investor still owns the
stock, he is exposed to all of its downside if the stock price falls.
(See sidebar.)
"So you accept less upside in order to have an
income stream, but you retain essentially all of the downside," Barnes
says. "Part of the reason you've given up some of the return is because
the broker must take their cut."
Not everyone realizes this because the fees on these deals are
essentially hidden, Barnes says. And in fact, the only people who
really know the size of the fees being generated are the investment
banks structuring these deals, he says.
"I've been around. This ain't my first rodeo. I know
how these things work," he says. "They're doing this to make money, and
it's much easier to make money when they're not telling you how much
they're making."
Robert Gordon, president of New York-based
Twenty-First Securities Corp., gives the product a more mixed
reception. He says some deals add value, while with others, investors
would have been better off creating the commodities or real estate play
themselves. "I don't think you should paint them all with one brush,"
Gordon says.
A $100,000 structured note that offers principal
protection based on the upside of American stocks is not particularly
novel, Gordon says. Investors would be better served taking $80,000 and
buying, say, a five-year U.S. Treasury zero-coupon bond, which would
guarantee to give them $100,000 at maturity. Investors could then spend
the remaining $20,000 on call options on the S&P 500. That way,
they save 200 to 300 basis points in fees and are not subject to the
credit risk of the investment bank that structured the deal, he says.
"If someone thinks they're buying a note that
guarantees them their principal and pays 12%, they're wrong, and
they're being sold a bill of goods," Gordon says. "Those products are
nothing more than naked put selling-which most clients wouldn't
do-wrapped in the flag of a 12% note. The problem is, most people don't
know what they're buying."
Barclays' exchange-traded notes, on the other hand,
are a different story. Gordon believes they are a very good product
because the exchange provides much-needed liquidity, the fees are low
and there is less counterparty credit risk.