There’s No Such Thing as a Free Lunch–Looking Under the Hood of Structured Products

Written by: Christian O’Dwyer, CFA | Vice President

Investors should always be wary of promises of risk-free returns from their advisors and the products they recommend or sell. All investments carry a degree of risk, except for those rare cases of pure arbitrage. Successful long-term investors find opportunities where risk is garnered only when it is accompanied by a commensurate return. Structured products, which are typically designed and issued by financial institutions and sold by broker-dealers to individual investors, are a good example of strategies that frequently promise upside market participation alongside capital preservation. This article reviews the definition of structured products, how they work, how to analyze them, and their role in a diversified portfolio.

What Are Structured Products?

Typically, structured products are debt securities with a fixed maturity and include two components: a bond component and a derivative component. The bond portion of the note is the majority of the investment and provides principal protection. The embedded derivative may be linked to the performance of an asset, index, a single equity security, a basket of equity securities, interest rates, commodities, and/or foreign currencies. The notes are used to modify market exposure, or otherwise manage market risk, credit risk, or both. The type of derivative embedded in the note will affect the performance characteristics of the note and the complexity of performance calculations. The products typically employ a degree of leverage.

 
07-17-2019.png
 

How do Structured Products Work?

The below image provides an example of a theoretical structured note. Consider a simple, three-year, S&P 500 index-linked structured note with 100% principal protection promising preservation of capital, 80% participation with the index and a capped return of 20%. The various return scenarios are depicted:

How to Analyze Them?

While our example was (hopefully) useful from a conceptual standpoint, it was very basic as compared to most structured products in the market. As features are added to the products, complexities mount making appropriate levels of due diligence more difficult. In response, the U.S. Securities and Exchange Commission issued a 2015 bulletin that plainly stated, “While structured notes may enable individual retail investors to participate in investment strategies that are not typically offered to them, these products can be very complex and have significant investment risks. Before investing in structured notes, you should understand how the notes work and carefully consider their risks.” Additional considerations are listed below.

  • Know the fees and other costs associated with the investment.

    • Structured notes are highly complex and carry low fee transparency; it is important to fully understand both the stated and embedded costs associated with the product.

  • Know whether the product is appropriate for the intended investment objective.

    • Are the risks associated with a particular structured note within your tolerance for risk, or are your investment needs better served by investing in another product?

  • What other investment choices are available to me? Are other products available that provide investment exposure to similar assets, indices or strategies? If so, how do the costs of these other products compare to those associated with the structured note?

    • Carefully consider what might be a suitable investment for you, and whether there are better alternatives to the structured note you are considering. For example, can I purchase some or all of the components of the structured note separately for a better price?

  • How long will my money be tied up?

    • Many structured notes are meant to be held to maturity. If you need your money back prior to maturity, you could lose a significant portion of your investment.

  • Are potential returns limited?

    • Some structured notes have caps on the returns that can be earned based on the performance of the reference asset or index. This is an example of a potentially significant embedded cost.

  • What is the credit risk of the issuer of the structured note?

    • Remember that any payoff on a structured note is subject to the creditworthiness of the issuer. Be sure to understand the financial condition of the issuer and read its disclosures as carefully as you would for any other investment.

For more information, please visit: https://www.sec.gov/oiea/investor-alerts-bulletins/ib_structurednotes.html

What is the Role of Structured Products in a Diversified Portfolio?

While the capital preservation feature and the customization of structured products can make them attractive for potential investors, the complicated payoff profile, opaque expense structure, lack of liquidity, and associated credit risk decrease their usefulness within a broad portfolio context. Investors should also consider opportunity costs associated with forgone investments in their overall strategy. In sum, the time-tested qualities of remaining patient, keeping costs low and being well diversified are most likely to drive long-term investment success.


About Innovest

For more than 20 years, Innovest has provided excellent client service as well as forward-looking, innovative investment solutions for endowments and foundations, retirement plans, and families. We are an independent provider of investment-related consulting services and work on a fee-only basis.

SECURE Retirement Act: Ten Potential Impacts

The U.S. House of Representatives made a significant step toward retirement reform by passing the Setting Every Community Up for Retirement Enhancement (SECURE) Act in May. While the act has not been taken up by the Senate or signed by the President, it points to some significant changes impacting individuals and plan sponsors. Click here for a three-page overview from Plante Moran.

Source: Plante Moran

Innovest Launches Innovest Family Office

“Longtime Denver investment manager and consultant Innovest Portfolio Solutions has united with Denver-based CPA and multi-family office firm Elevation Management Group to create Innovest Family Office. The office will be owned jointly by Innovest Portfolio Solutions and Elevation Management Group founder Karen Winkelman, who will be the new group’s CEO.” Click here to learn more.

Source: Denver Business Journal

Innovest's 23rd Anniversary

We are excited to celebrate our 23rd Anniversary today on July 1, 2019. At Innovest, we are not just an investment firm, we are stewards to our clients, employees and community. Everyone knows about the problems on Wall Street.  Things were no better in 1996 when the co-founders of Innovest left their Wall Street firm because of the conflicts of interest and tainted objectivity to start their own firm.  They started the firm with five employees, 25 clients, and a Ryder truck full of used office furniture (driven by President Wendy Dominguez).  With relatively little except for the desire to be stewards for our clients, Innovest was founded.  The firm has come a long way since that day in July – today, Innovest has 49 employees and more than 260 clients.  Innovest consults more than $23 billion in assets. We have a client-based culture, a fee-only model and we are completely independent with no conflicts of interest.

Rich Todd, CEO, reflects, “Wendy and I were tired of the conflicts of Interest on Wall Street and decided to start our own conflict-free firm with tenets: independent, team-based, and research-focused doing completely custom work. We have grown from 25 clients, 5 employees, and 250 million in assets under advisement to over 200 clients, 49 employees and almost 25 billion assets under advisement.”

While Innovest has grown significantly, a major strength of the firm is to make Innovest a rewarding place to work.  Pensions & Investments named Innovest among the Best Places to Work in the nation in 2018, 2017, 2016 and 2014.  This achievement has allowed us to hire and retain top quality talent with the highest integrity who are committed to our clients. Our employees are people who put others first and work for the best outcomes for our clients and community.

We have promised clients that they will benefit from our growth through our continued hiring of high quality, experienced professionals, and the acquisition of top-notch research.  Our success is attributed to our strategy of building community within our clientele and developing them into a great sales force.  It is important to Innovest to build strong relationships with our clients, but also provide educational settings in which they can enhance their knowledge about the economy, capital markets, and fiduciary/compliance issues.  Innovest founded the Rocky Mountain Nonprofit Conference, Rocky Mountain Benefit Plans Conference, and the Colorado Public Plan Coalition, all of which provide education to hundreds of investors, trustees, and investment committee members – both clients and non-clients.

innovestps
Around the Firm

Innovest wouldn’t be the firm it is today without its dedicated employees who are committed to providing great service to our clients.  Beyond service, Innovest employees are known for being diligent, collaborative, honest and for seeking continual development.

We’re excited to celebrate the recent accomplishments of several Innovest employees!

Promotions:

Kathy Lalone, Kyli Hanson and Kenny Senour were all promoted to Manager positions.

Cheryl Wilks, Christine Hudek and Jordan Rice were named Lead Senior Analysts.

Eileen Pohs was promoted to Senior Analyst.

In addition, Zach Heath and Brooks Urich were elevated to Analyst. 

Speaking Engagements:

Vice President, Jared Martin, spoke about Financial Wellness for Plan Participants, at the College and University Professionals Association Annual Conference in Arizona on 6/21.

Marianne Marvez, RPA, Vice President, gave a workshop on What to Expect from your Service Providers at the PlanSponsor conference.

Continuing Education:

Congratulations to Kenny Senour and Jordan Rice for passing their CFP exam!  Earning the CFP designation involves meeting requirements in formal education, performance on the CFP exam, relevant work experience, and demonstrated professional ethics.

innovestps
Risky Business

By Kristy LeGrande, CFA, MBA, Principal

Acclaimed investor Warren Buffet summed up risk when he said, “Risk comes from not knowing what you are doing.”  So, what is risk?  How do we measure and monitor it?  How can we protect against it?  How much risk should we take?  There are numerous types of risk in the investment world and it is crucial that investors understand these risks and take steps to monitor them. 

In an attempt to educate investors, below is a list of some of the main types of investment risk, and, importantly, how they can be prudently monitored. 

Type

Financial Risk

Definition

Risks from heavy use of leverage or unsustainable spending rate that could jeopardize corpus longevity.

Who Monitors and How is it Monitored?

Client. Monitors through financial statements, prudent decision making by Board of Directors/Investment Committee/Family Decision Makers. Innovest assists clients through education.

Type

Volatility

Definition

Return fluctuation for a given security, strategy, market or portfolio, i.e. the potential range of a change in the security’s value. Higher volatility means price can change dramatically over time in either direction while lower volatility implies less price fluctuation in either direction.

Who Monitors and How is it Monitored?

Investment Consultant. Addressed through prudent asset allocation using non-correlated assets to mitigate portfolio-level volatility. Monitors volatility at the portfolio level and fund level in quarterly reports and annual asset allocation study.

Type

Market Risk

Definition

The risk and impact of equity market moves on an investment and on the portfolio as a whole.

Who Monitors and How is it Monitored?

Investment Consultant.  Monitors through in-depth diligence and continual monitoring of each investment strategy as well as through careful portfolio construction, including the addition of diversifying, non-correlated investment strategies.

Type

Liquidity Risk

Definition

Inability to sell an investment quickly either due to terms of investment contract or thin market with limited or no buyers.

Who Monitors and How is it Monitored?

Investment Consultant. Monitors through a liquidity schedule for the entire portfolio that demonstrates the availability of invested assets over time based on specific terms of each investment.

Type

Inflation Risk

Definition

The damaging effect that rising inflation rates can have on future purchasing power and erosion of real return on invested assets.

Who Monitors and How is it Monitored?

Investment Consultant. Monitors through the portfolio return target, which is represented as the return in excess of inflation (CPI +) and tracked over time. Use of asset classes with above-inflation returns protects purchasing power.

Type

Downside Risk

Definition

Estimation of the amount of loss a portfolio could sustain as a result of a decline arising from factors that affect the market as a whole or asset classes in particular (recession, loss of confidence, geopolitical events, etc.)

Who Monitors and How is it Monitored?

Investment Consultant. Monitors potential downside risk at the portfolio level. Downside risk is reviewed and quantified annually in an asset allocation study.

Other risks for investors to be aware of when constructing and monitoring portfolios include:  tracking-error risk (an investment strategy’s deviation from its benchmark), key person risk (risk of the departure of an investment strategy’s key decision maker), headline risk (risk of adverse news stories impacting the price of individual securities, strategies, or asset classes), factor risk (risk of having intentional or unintentional factor exposures in the portfolio), interest rate risk (risk and impact of changes in interest rates), credit risk (risk related to the credit of a borrower), counterparty risk (possibility that the other party in an investment, credit, or trading transaction may default on the contractual obligation), maverick risk (risk associated with venturing outside investment best practices or engaging in overtly risky positioning or strategies, i.e. a highly concentrated portfolio), legal risk (potential financial loss due to a contract between two parties being considered unenforceable), geopolitical risk (chance that an investment's returns could suffer as a result of political changes or instability), currency/exchange rate risk (the possibility that currency depreciation will negatively affect the value of investments) and other macroeconomic risks.

Risk is unavoidable in the investment world.  It is crucial that investors determine their risk tolerances and are aware of the risks they are taking in their portfolios.  In addition, investors along with their advisors, must take steps to quantify risk when possible, understand the qualitative aspects of risk, and monitor risk on an ongoing basis.

About Innovest

For more than 20 years, Innovest has provided excellent client service as well as forward-looking, innovative investment solutions for endowments and foundations, retirement plans, and families. We are an independent provider of investment-related consulting services and work on a fee-only basis.

11 Trends in Philanthropy for 2019: Anticipate and Embrace What's Next

“Giving in the United States has now topped $400 billion. Countless community and national organizations are benefiting from a surge in public interest and a growing conviction that renewing our democracy will require that we work together. The entire ecosystem of philanthropy — nonprofits, foundations, donors, and volunteers — is rallying to the cause of civil society and cross-sector collaboration.” Click here to keep reading.

Source: Johnson Center