Posts in Investment strategies
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.

 
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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.

The Grinch Comes to Loanland, but Expect a Short Visit

“Just seven short weeks ago, the floating-rate loan market was standing tall with 4.0% year-to-date return through October. Not only were loans on pace for the 5%+ calendar year mark that many anticipated, they had performed with remarkably low volatility and a performance profile that trumped all major asset classes.

Enter the Grinch.

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Source: Eaton Vance

Avoid Emotional Investment Decisions

Authors: Chris Meyer, Innovest Vice President and Abigail Thomas, Innovest Lead Senior Analyst

Imagine waking up on Saturday morning in early April of 2016, ready for a sip of coffee and a quick look at how your investments performed during the previous quarter. Your eyes land on Harbor Capital Appreciation, your large cap growth fund. The performance numbers catch your attention, but not in a good way. The fund was down 5.49% in the first quarter, while the benchmark, the S&P 500 Growth Index, was up 0.53%. Instead of essentially breaking even with a low-cost index fund, you paid active management fees and lost about 5.5%, in one quarter? Harbor Capital Appreciation seemed like a poor investment. Surely you could have been invested in something better. You decide that you are going to call your advisor and discuss replacement options.

Why Do I Think This Way?

You pause long enough to eat breakfast before making the call, which allows your emotion to subside a bit. Reflecting for a moment, you ask yourself: Why the immediate, emotional reaction to last quarter’s poor performance? Because you are human. Our decisions are often influenced by the subconscious biases that swirl around beneath our conscious reason. Some of those cognitive biases can help explain why it is so easy to make a snap judgment when confronted with an investment loss.

Paying Too Much Attention to Recent Pain

People tend to experience the emotional pain of negative events, including investment losses, twice as strongly as they experience positive emotions from good events, like investment gains. To state the principle conversely, a positive experience creates about half the amount of emotional impact as a negative one. Paired with human tendency to allow emotions to influence decisions, it’s a recipe for less-than-rational decisions.

These tendencies are a central feature of Kahneman and Tversky’s 1979 prospect theory, which argues that people derive utility, or satisfaction, from changes in wealth, rather than from absolute levels. A simple example illustrates the concept: A person given the choice between 1) receiving $20 and 2) receiving $40 then immediately losing $20, will typically choose the former. That is true even though each situation results in the person having $20; the loss involved in situation two makes it much less appealing.

Another obstacle to investing rationally stems from the human tendency to give more weight to events that occurred recently as compared to events in the more distant past. Despite many past quarters outperforming most large cap growth managers, Harbor Capital Appreciation’s recent performance had been poor, which could have resulted in our human brains judging the investment as an overall poor performer.

These recent, painful experiences are sometimes distracting from other highly relevant data points. Here, investors may have trouble seeing past recent poor performance despite understanding that performance is only one of many factors that should bear on selecting a mutual fund. After all, investors ought to give great weight to qualitative measures of investment process, style, and personnel, along with the fund’s historical performance.

What Happens if I Act on These Tendencies?

Typically, reacting to recent underperformance is a recipe for mediocre investment results. A 2008 study examined the behaviors of 3,400 retirement plan sponsors between 1994 and 2003, specifically focusing on 8,755 manager hiring decisions1. The study showed that fired managers tended to outperform their replacements during the three years after the change, even when their historical returns outpaced the fired manager over the previous three years.

What Should I Focus on Instead?

First, remember every fund will underperform for periods of time. The reasons can vary from market cycle, to the fund’s investment decisions taking time to play out, to the manager’s unique style simply being out of favor. Diversification—investing in several different asset classes— typically results in a mix of investments outperforming and underperforming in all market environments. This fund diversification normally lowers the portfolio’s volatility, reducing the shock that any one market factor can have on the portfolio.

Second, consider both quantitative and qualitative measures when monitoring an investment. At Innovest, we pay close attention to the fund’s investment style and strategy, the manager’s experience and credentials, and the overall organization structure and governance. When we score an investment highly in these categories, it means that we have conviction that the necessary pieces are in place for the investment manager to execute a thoughtful and proven strategy that will achieve the fund’s stated goals. Paired with the quantitative measures of the fund’s size, performance, and costs, these qualitative criteria provide a robust picture of an investment and its suitability for your portfolio.

So, when should performance be an issue? When the underperformance is inconsistent with the investment manager’s process or style, or is the result of a significant process or personnel change, an investor should closely examine the merits of changing managers.

Returning to our Harbor Capital Appreciation example, the underperformance relative to the index experienced in the first half of 2016 was not inconsistent with the established investment process, was not the result of a change to fund management and was not a problem warranting manager replacement. Changing funds would have been a mistake.

In fact, if you avoided the pitfalls described above and remained invested, you would have been rewarded with a total return of 22.77%, 2.27% in excess of the S&P 500 Growth Index return of 20.50%, for the period April 2016 through June 2017. Qualitatively, the same investment team has continued to employ the same investment strategy. This includes a willingness to significantly overweight sectors that the team expects to outperform.

To be clear, this example does not prove that every underperforming fund will have an incredible upswing in the following year. Nonetheless, we believe focusing on short-term performance can distract investors from more meaningful factors and lead to suboptimal investment decisions.

1 Goyal, Amit, and Sunial Wahal. “The Selection and Termination of Investment Management Firms by Plan Sponsors.” THE JOURNAL OF FINANCE, LXIII, no. 4, Aug. 2008, pp. 1805–1847.

Source: Innovest