Structured products are complex and their promises dazzle unsuspecting investors. They advertise guaranteed income payments, promise that you won’t lose money, and offer you only the upside potential of the markets.
However, once you understand how structured products are made, it is easy to see why you wouldn’t want one.
Imagine that we are going to invest $10,000 in a structured product, built from four different components:
The first component is a zero-coupon 10-year bond. A zero-coupon bond does not pay interest (coupons) at regular intervals. Instead, all the earnings are gained from the value of the bond at maturity (face value). Because all the earnings are made on the difference between the face value and the purchase price, zero-coupon bonds are sold at a deep discount from face value.
Our structured product purchases a 10-year zero coupon bond whose face value is worth the entire amount of our invested capital. Since this type of bond can be bought at a deep discount, this purchase only requires a small portion of our money. For example, a $10,000 10-year zero-coupon bond with an effective annual interest rate of 5% would cost just $6,139. This purchase satisfies the guarantee that they can return our initial investment in 10 years.
The remainder of our investment is spent satisfying the next three components.
The second component is 10-year fixed annuity. Annuities provide a guaranteed income stream. At 5% interest, you can purchase a 10-year $20 monthly annuity for $2,400. This would be advertised as a 2.4% guaranteed payment in addition to the guaranteed principle from the bond. (Products which do not offer an income stream simply skip the annuity and invest more in the remaining components.)
The third component is periodic call options. A call option is the right to buy — but not the obligation to buy — stock shares at a specific price. Buying an option to purchase the S&P 500 at a certain price means that if the S&P 500 goes above that price, you make a profit. You can either buy the shares at a lower price or sell the option itself for a profit.
If the S&P 500 goes below that price, you’re not obligated to buy and can let the option lapse. You do lose the money you paid to buy the option, but it’s cheaper to buy an option than the shares themselves.
Buying an option satisfies the potential to participate in the upside of the markets.
The fourth and final component is fees paid to the company offering the structured product. The structured product company takes anything left over after purchasing these three components as their fees. Fees vary, but these fees are just the profit of having created a complex product that most people don’t understand.
If you wanted to, you could create your own structured product and keep the profit for yourself.
Principle protection is one of their primary selling points of structured products. However, there are much easier and less costly ways to get more principle protection.
In our hypothetical 5% interest rate environment, if you simply invested the entire $10,000 in zero coupon bonds, you would have $16,288.95 at the end. This would be a 62.89% return with no loss of principle.
If you are willing to take more risk, you could put the $10,000 into the markets. If we look at the S&P 500 Price Index (because it represents market volatility better than the Total Return Index which includes reinvested dividends), you would earn 111.60% over an average decade.
Doubling your money every decade is average in the stock market. Only about 8.24% of ten-year rolling returns have been negative. Using total return numbers which include dividends only improves these returns.
Structured products violate three of our Safeguarding Your Money principles: 1) the complexity is hidden such that investors don’t understand it; 2) it sounds too good to be true; and 3) investment companies tend to sugarcoat reality.
Structured products are not worth the cost. The “potential to participate” in the upside of the markets is too small, as reflected by the average returns. Every structured product has different rules. Unless you read carefully, you won’t even understand why you are getting below market returns until it is too late.
InvestmentNews describes some of these limitations in “Structured notes offer too-good-to-be-true returns .”
That doesn’t sound so bad until you read the fine print in the note’s prospectus: “The notes are designed for investors who seek a return of 1.5 times the appreciation of the S&P 500 Index up to a maximum return of 14.00% at maturity. Investors should be willing to forgo interest and dividend payments and, if the Ending Index Level is less than the Initial Index Level by more than 10%, be willing to lose up to 90% of their principal.”
A few things in those sentences should give investors pause. First, there’s that 14 percent cap. Since market returns tend to be lumpy, there are often years where the market is up 26.5 percent, like 2009, and other years where it does next to nothing, like in 2011, when it returned 2.11 percent. Capping the upside at 14 percent could mean giving up a lot of return in a strong year.
And if the market returned just 2.11 percent over the life of the note? That would translate into a 3.16 percent return. Alternatively, if the market was down 20 percent when the note matured, the note would absorb the first 10 percent of the loss, and the rest would come out of the investor’s principal. The reward doesn’t seem quite worth the risk.
Given the purposeful complexity and limitations to structured products we suggest you avoid them. It is better to keep 5-7 years of spending in relatively safe bonds and put money that you won’t need until 8 years or longer in the markets.
Photo by Duncan Sanchez on Unsplash