I recently came across a 7 year note offering 300% uncapped upside participation in the Goldman Sachs Momentum Builder Multi-Asset 5 ER Index (“The GS index”) with full principal protection. One of the best headline offerings you will ever see; to put it in perspective, a typical S&P note of the same duration would offer about 65% participation.
How can this note offer a return that is so compelling? As I have pointed out in prior blogs, there is no free lunch. Return is generally a function of risk, so there must be something more beneath the surface.
Let’s investigate the underlying index.
The GS index is a momentum-driven low volatility strategy that creates a basket of the best recent performers among a selected group of 14 ETFs across six asset classes. (The GS index is almost identical to the JP Morgan ETF Efficiente 5 Index, which has raised well over $1 billion in AUM since issuance. Recently, an ETF based on the Efficiente 10 index launched.)
I’m pleased to announce that I will be speaking at the Investment Management Consultants Association 2014 Winter Institute. This year’s event will take place on December 8th, 2014 in Phoenix, AZ.
My presentation, “Simplifying Complex Products and Concepts: Using Some of the Most Controversial Products in Favorable and Conservative Strategies”, will pull back the curtain on several complex products and discuss how traditionally “risky” investment products and features such as leverage, derivatives, and structured notes can be used responsibly to achieve some powerful investment results.
It promises to be a great conference. Please let me know if you plan on attending and if you’d like to get together to explore this topic further.
Introducing our first “Structured Notes Gone Wild” segment – the most interesting, unusual, or just wacky ideas we’ve come across. One of the compelling elements of structured investing is that design is only limited by the human imagination. Below, I highlight five of the most creative notes I have come across, two which were mentioned in a recent WSJ article by Jason Zweig.
2x – 3x Leverage Trigger Note
Characteristics: Investor receives 2x upside exposure to the common stock of Bank of America up to a cap of 18.10% unless the stock falls below 95% of its initial price during the first three months of the note, in which case the investor receives 3x leverage up to a 27.15% cap; full downside exposure.
I recently authored an article on structured note annuities which appears in the October 2014 issue of California Broker. They have graciously allowed me to it reprint here:
The structured note annuity (SNA) is a compelling and important offering that will profoundly affect the insurance complex. The flexibility of SNAs to match risk/return objectives opens the door to meeting a wide array of client needs that are not well met within existing annuity programs.
The launch of fixed indexed annuities (FIAs) in the 1990s was an innovation on a longstanding fixed annuity model. Owners could take a little risk on the yield in return for a higher potential payout. Using current pricing, a fixed annuity might offer a set 2% annual yield whereas an FIA would pay up to 3.5%, depending on market performance. Driven by the promise of greater upside, FIAs have grown to roughly $40 billion in annual issuance from their inception 20 years ago.
Fifteen years after the introduction of the FIA, a new annuity category was born: the structured note annuity (SNA). For brokers and clients alike, SNAs introduce increased flexibility to match risk/return objectives with an additional tool in the annuity product line. The insurance industry is increasing the level of risk in return for higher potential returns. Thus, while FIAs are limited to fully principal protected products and relatively modest caps, SNAs offer products with a defined level of principal at risk in exchange for higher profit potential.
In July we broached the topic of leverage in a post titled “5X Leverage – Sane or Insane?” For those wondering, the answer was sane – the note should outperform the Euro Stoxx index it tracks if 5-year annualized returns, inclusive of dividends, are between 1% and 12%. Since the historical 5 year annualized return for Euro Stoxx is approximately 8.5% (assuming a 2.5%-2.75% annual dividend), outperforming the index so long as the index is below 12% is compelling.
Today I would like to examine a different leveraged structured note that has attracted significant investor interest – 3X strategies on the S&P 500 have attracted well over $1 billion in notional this year. I will focus on eight notes (here’s the most recent one) struck roughly a month apart over the course of the first eight months of 2014, each with a notional of over $100 million.
As a Deconstructed Notes follower, you probably know my take on structured investing – the beauty lies in the limitless tailoring that can be applied to meet investor needs. On the flip side, the industry as it stands today is tainted with real and perceived issues, such as concentrated credit risk and concerns surrounding liquidity, transparency and cost.
The goal of my firm, Exceed Investments, is to develop next generation structured investments and strategies that offer the defined outcome benefits of structured notes while mitigating the issues they present to investors.
Today Exceed has announced the launch of a family of structured indexes in partnership with Nasdaq OMX. They are the first indexes of their kind, offering the benefits of defined outcomes within an index methodology. The Nasdaq Exceed family of Structured Indexes offer investors a controlled range of investment outcomes, all based on specific levels of protection and/or enhanced return that investors can select.
With Labor Day quickly approaching and summer coming to a close, it seems like an opportune time to provide an update on some of the prior stories we have featured.
One of the trends we have focused on are callable products. The reason we have tried to shine a light on this area is that structured call features tend to result in nice headlines featuring attractive long term appreciation potential, but in reality often result in returns or exposures which are less attractive for one reason or another.
In my last blog post I discussed leverage as a tool to outperform in certain market environments. The various investment options we reviewed were all focused on increasing or otherwise shaping the upside potential of structured investments. Now let’s take a look at another aspect of structured investing – the various tools available to protect against downside exposure.
Why are we interested?
When including dividends, the S&P 500 has returned roughly 125% over the prior 5 years despite sluggish domestic growth and political infighting in Washington. With the secular bull market now getting a bit long in the tooth by historical standards, investors may be looking for ways to continue participating in equity markets while adding a degree of protection to their investments.
While a number of investment products provide elements of protection (e.g., low vol funds), structured notes are one of the few products that can offer defined outcomes. Let’s analyze the characteristics and costs of some of the more popular protection-themed structured note offerings.
I have recently come across a few highly leveraged structured note offerings. One such note that caught my eye was a 5 year note offering 5x the upside performance of the popular Euro Stoxx 50 Index, up to a cap of 94%. The structured note offered no principal protection and exposed the investor to 1x downside exposure.
Why are we interested?
Leverage is a dirty word in securities investing, with good reason – margin investing is a risky enterprise unsuitable for most retail investors due to margin call potential, whereas leveraged ETFs provide the twin dangers of value decay due to daily compounding and leveraged downside.
In contrast, one of the benefits of structured investing is that leverage can be responsibly employed without the typical dangers. For starters, there are no margin calls to worry about. In addition, structured note leverage is not compounded daily, as leveraged ETFs are, but rather operates from inception to maturity. That means if the underlying index increases 10% over the 5 years to maturity, the issuer is obligated to pay out a 50% return (10% * 5x). Thus, there is no decay concern as is typically found in leveraged ETFs.
Furthermore, there is no leveraged downside in this particular investment – whereas it offers 5x upside, there is only 1x downside – not a bad tradeoff!
This morning Vertex Pharmaceutical (VRTX) announced positive results for phase 3 clinical trials. As a result, the stock soared 50%+ pre-market, surpassing $100 for the first time in the firm’s history. Of course, an unsuccessful outcome would have resulted in an extraordinary move in the opposite direction; clinical trial outcomes such as these present extreme binary events to investors.
In late February, 2014, a structured note was issued with roughly $20 Million in notional on VRTX. As I wrote in my blog post on binary events, this structured note presented investors with two unattractive outcomes – if the VRTX clinical trial was successful, the stock would appreciate significantly and the structured note would be called early and investor returns would be capped at a modest 5.5% yield (about 11% annualized). If the trial was unsuccessful, the stock would take a substantial hit, perhaps substantial enough to eliminate any principal protection and thus expose investors to a major loss.
Note in this document, structured investments are synonymous with structured products. Both refer to the class of products typically issued by banks to retail investors with such customized features as principal protection and leverage.
(New York, June 19, 2014) – In a survey of 700 financial advisors, Exceed Investments found that perceived and structural inefficiencies were holding back latent demand for structured investments with 20 percent of all respondents saying they would sell considerably more structured products if liquidity and transparency were improved. Furthermore, 20 percent of RIAs said they would like to sell structured products to at least some of their clients but don’t have access to the product.
The survey also explored motivations driving the usage of structured products, finding that 80 percent of respondents cited protection against index declines as the most compelling structured feature. Along similar lines, 60 percent of active structured product users identified the ability to customize risk/reward tradeoffs as the main driver of their usage.
For those of you attending this years North American Structured Products Conference, I’ll be participating in a roundtable discussion “What Do Buy-Side Clients Really Want?” Joining me will be Eric Glicksman, Managing Director and Head, Structured Solutions for UBS in the Americas and Deryk Rhodes, Executive Director, Structured Products Trading at InCapital LLC. Discussion topics include:
- Distribution of structured products for private banks, institutional, and retail clients
- What products are flourishing as investors move to “risk-on”
- Secondary market pricing
- The role of structured products in retirement solutions
It promises to be a great discussion and conference.
The conference takes place at the Seaport Hotel in Boston on June 26th and 27th, with the roundtable discussion on Thursday the 26th at 2:20PM.
Additional details can be found on the conference website
This past week I came across an interesting survey conducted by Russell Investments on Smart Beta indexes.
For starters, what is “Smart Beta”? That can depend on who you ask; the consensus definition in this survey was “Alternative ways to construct market exposures such as minimum variance, fundamental weighting, maximum diversification, equal risk, or equal weighted”.
Why are We Interested?
One of the key findings of the survey is the “greatest unmet [investor] need is for smart beta indices that control exposures.”
While survey designers focused on Smart Beta funds as a means to solve this unmet need, let me propose another: Structured notes! Structured notes can be easily used to control unwanted exposures, and at times to introduce new ones.
Structured Note Annuities (SNAs) are a relatively new retirement product within the insurance complex; they are poised to become a breakout product due to their ability to provide defined exposures for investors, similar to bank issued structured notes, while minimizing basis risk for insurers.
I recently co-authored an in-depth article on SNAs which appears as the cover story for the April/May 2014 issue of The Actuary, the magazine of the Society of Actuaries. (The Society is the largest professional organization of its kind in the US, serving 23,000 members). Some highlights of the article include:
Imagine you purchase Apple stock. By definition, you and the seller are on opposites sides of a binary trade – if Apple zooms up, you will have made money and the seller will presumably regret selling, and vice versa. Apple is most likely going to move one way or the other, so there’s going to be a winner and a loser.
Do structured notes present a similar binary outcome between buyer and seller? If the investing purchaser makes money, does the issuing bank lose money? And vice versa? The answer is a resounding no!
Why Are We Interested?
Purchasers of structured notes sometimes believe the issuer automatically wins when they lose, which would place a bank in conflict with their clients. The short answer is that this is not the case. The outcome is not a zero-sum game, and ultimately both the investor and bank can win. It is in an issuer’s best interest for the client to win in the long run as this would lead to an increase in both business and revenue – so yes, trading desks (mostly) root for the client. In this post, we will discuss the makeup of a structured note and how the trader at the issuing bank treats the product very differently than the client, resulting in a potential win-win situation.
A recent structured note caught my attention because it a) offered great characteristics and b) was based on an underlying biotechnology stock. These characteristics suggest that note performance may be tied to an upcoming binary, highly volatile event Did investors pick up on this prior to putting $20M notional into this note and do they understand the implications as relates to the note?
Why are we interested?
Binary outcomes make for complex and interesting analyses. Today’s blog will focus on options and notes referencing stocks whose performance is subject to binary outcomes (e.g., Biotech companies facing drug trial results, companies with upcoming major litigation decisions, and so on); these investments require a very different kind of analysis than your everyday stock, so investors should tread carefully.
An advisor recently asked me to evaluate a structured CD he was considering; the market linked CD paid a variable coupon derived by the performance of a basket of 10 stocks.
Why are we interested?
For this particular investment, the correlation between the 10 stocks has an outsized impact on total returns; in fact, it is impossible to effectively evaluate this investment without analyzing the correlation among the securities in the basket. My goal today is to define correlation and show its effects on everything from investments to the NBA draft.
One of my favorite advertising slogans from childhood was the Wendy’s “where’s the beef?” question regarding competitor (i.e., McDonalds and Burger King) hamburgers.
I often hear a similar question regarding structured notes – “where’s the dividend?” A key difference between structured note investments and more traditional securities is the lack of a dividend in most structured notes. For example, a note linked to SPY (the S&P 500 ETF) will not necessarily pay out any yield or dividend despite the fact that SPY itself does pay out a dividend. This disparity results in an assumption by some investors that the issuers “pocket” the missing dividend and thereby deprive investors. This is simply not true – the dividend, or lack thereof, is taken into account when creating and pricing a structured note. Today we will explore just how the reference security’s dividend does get utilized in the pricing of a structured note as well as in OTC and listed options.
Happy 2014! In the spirit of New Year’s resolutions, we thought this would be an opportune time to help investors reduce risk by developing a checklist template specifically crafted for structured note investments.
As I hope you know from reading this blog, I am a strong believer in structured products. They are customizable instruments that empower investors to achieve all sorts of investment objectives that are difficult, if not impossible, to replicate through other means. I am also a big proponent of investor education, especially as relates to structured notes, because they tend to be complex, are often misunderstood, and are not always the best means of achieving an investors goals. In that spirit, I have developed the following Structured Notes Investor Checklist. It includes important questions that every investor should address carefully before purchasing a structured note. As always, I look forward to your feedback and comments.