Do Structured Notes answer Smart Beta investor’s greatest unmet need?
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.
Let’s take a look at some recently issued structured notes to illustrate how they achieve a defined outcome, thereby controlling for unwanted exposures and solving the need highlighted by the survey. A defined outcome is an investment whereby the investor knows in advance how a product will perform in different market environments.
A recent note on the S&P 500 (“Note #1”) offered a 10% buffer on the downside while providing 150% participation on the upside, to a maximum gain of 15.75%. This was a two year note, and parameters given apply for the entire 2 year period, not for each year – e.g., maximum 2 year gain is 15.7%. The note provides a defined outcome in that the investor knows in advance he or she is protected against up to a 10% decline while enjoying enhanced participation in moderate market increases. An investor with a moderate outlook who seeks to control exposure to market downturns might find such a product more interesting than a direct investment in the S&P 500.
Note #1 Performance vs. S&P 500 – 2 Year Outcome:
For an investor looking for more protection, a longer dated (5 year) recent note on the S&P 500 (“Note #2”) offered a 30% buffer on the downside while providing 100% participation on the upside, up to a cap of 40% (As with the other note, characteristics refer to performance over the full 5 year period, not per annum). This note may match the objective of an investor who is interested in receiving a modest market return but cannot afford to take material risk; the defined outcome here provides significant control against any unwanted exposure.
Note #2 Performance vs. S&P 500 – 5 Year Outcome:
To recap, both of these structured notes provide a defined outcome for the investor, mitigating downside risk in return for capped performance. Note that neither note provides the dividend of the S&P 500 so comparisons are vs the S&P 500 price performance. Reference our post on dividends to learn more about how dividends are incorporated within structured investing.
Like Smart Beta products, structured notes are generally passive investments referencing a specified index or security. Unlike most Smart Beta products, structured notes are able to give precise expected outcomes based on market performance.
For instance, low volatility strategies are a Smart Beta category that has generated a fair amount of “buzz” in recent years. I believe the main appeal for the category is it seemingly provides a more controlled level of exposure to the market. However, unlike a structured note, a low volatility strategy does not provide a defined level of protection.
For example, if the S&P 500 declines 30% over the next several years, a low volatility strategy based on that index will most likely decline less due to it having a lower beta – however, it is not defined. Therefore there is no way to know whether it would indeed outperform the S&P 500 and by what amount.
In contrast, a structured note investor would know precisely what outcome to expect based on the terms of the note – this is the power of structured investing. Coming back to the notes we reviewed, let’s see how each would have performed in a 30% decline environment. The first note protects the investor against the first 10% decline in the market. Losses below 10% have a participation level of 111.11%, meaning that a 30% decline in the S&P would result in a loss of 22.22%. The second note would provide protection for the full 30% decline.
In summary, structured notes offer investors straightforward expected results based on market moves. Based on the Russell survey, it seems like this is something investors are looking for.
 Greatest unmet need was derived by Russell through comparing the importance of investment objectives with satisfaction levels.