08/19/2015

Response to a Biased Article on Structured Notes

I recently came upon a Seeking Alpha article by Alliance Bernstein titled Structured Notes: Read the Fine Print. The article expressed a fairly negative and, in my opinion, inaccurate view of structured investing based on an analysis of one structured note in particular. As an experienced structurer and trader prior to founding Exceed Investments, I’d like to help set the record straight.

The article analyzes a 5-year 28% buffered note on the S&P 500 as an example. While they do not share a link to the terms, the note is similar to, if not exactly the same, as this note.

First, let’s briefly consider what a structured note is and discuss its purpose.  Structured notes are an example of what I call “defined outcome” investments, which are options-based strategies that allow investors to shape a risk/ reward exposure to fit their personal objectives. In these strategies, market participation levels are preset. Therefore, the targeted downside participation is known in advance, as is the upside potential.

A defined outcome investment can be built to introduce risk, reduce risk, or modify it – in this case, the 28% buffered note offers S&P exposure with a material level of downside protection, which I will refer to as downside “insurance” in this article. Performance at maturity, assuming no default of the issuer, looks like this (X axis is Adjusted S&P 500 return; Y axis is the Note return):

chart

 

An investor may be interested in this product if they are risk-averse but still want to participate in equity markets (e.g., an executive who is retiring in 5 years from now and can’t take a big hit over the next 5 years).  The “insurance policy” of this note will cover up to 28% of downside “damage” 5 years from now – e.g., market down 28%, investor loses 0, market down 40%, investor loses 12%.

As in all insurance policies, a premium needs to be paid – in this case, the investor loses all dividends of the S&P 500.

Over 5 years, those lost dividends amount to about 12% in a reasonable model scenario (2% annual dividend rate, assumed reinvestment at a compounded 8%).  Is 28% of potential downside insurance worth giving up 12% of dividend upside, while still participating in the price appreciation of the S&P 500?  There’s no right answer to that question as it depends on an individual’s needs and perspectives.

As mentioned, I found a number of inaccuracies and misrepresentations (e.g., expense levels, liquidity) in the article but will focus on the main items which I found to be flawed.  To summarize:

  • The article directly compares the expected performance of the S&P 500 with the Note, without fairly pointing out the insurance benefit provided by the Note
  • The article then compares the performance of a balanced portfolio with the Note, which I find two issues with –
    • Why compare a product vs. a balanced portfolio? It’s an unfair comparison – no sane investor would invest all their funds in a single note
    • The balanced portfolio described is somehow expected to gain during equity declines as well as fairly closely match bull returns, which is just impossible

 

Greater detail follows:

  • “Our analysis suggests that this structured note has an 80% chance of underperforming the S&P 500 over the next five years…”
    • On one hand, while I can’t attest to the accuracy of their model, it seems reasonable. The note will underperform the S&P if the S&P finishes > -12% after 5 years.  That’s because the cost of the insurance purchased, (i.e., 12% of lost dividends), will be greater than the insurance “payout” if the market isn’t down by more than 12%.   Given historical performance, odds are the S&P does better than a cumulative -12% over the next 5 years.
    • On the other hand, this isn’t a fair statement. If an investor buys any type of insurance, (e.g., earthquake insurance, fire insurance, theft insurance) and there is no major catastrophe in the next 5 years, which is usually the case, the investor will lag the performance of people who didn’t buy insurance.  The same is true of buying 28% worth of portfolio insurance – if the market isn’t down by at least your premium spent, you will lag.  That obviously doesn’t mean ipso facto that no one should buy insurance.
  • “Projecting thousands of plausible outcomes across all types of market environments, we found that the median outcome for the structured note is more than 6% below what we’d expect from a fully diversified balanced portfolio, as the next Display
    • For starters, no reasonable investor would take all their assets and purchase this single structured note vs. choosing a balanced portfolio.
      • A more reasonable approach to this comparison may be to replace a relevant component of the balanced portfolio, for instance large cap value, with the structured note and then stress test outcomes between the two varying portfolios.
    • Now let’s talk about the finding that a balanced portfolio over 5 years results in a median 4.5% return when the stock market finishes down, and a median 38% return when the market finishes up (which is apparently just about equal to the S&P price return). While I am sure their model is well designed, this simply doesn’t pass the smell test. How did individuals with balanced portfolios do in 2008?  Hint: not very well.  I am not aware of any product or portfolio design that had positive returns in 2008 and then proceeded to equal the price return of the S&P 500 over the following five years.  If someone else is, please share it with me so I can invest.

In conclusion, while I acknowledge that Structured Notes have issues (I cover them in detail at the end of this white paper), which is what drove me to found Exceed Investments in the first place, this article does not treat them fairly. Ultimately, the referenced note provides a very defined risk / reward exposure to the S&P 500, providing a level of downside protection that may be deemed appropriate and/or may resonate for a subset of investors.

 

 

 

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