“Principal protection,” “capital guarantee,” “absolute return,” and “minimum return” are all terms used to describe structured notes. Unfortunately, many structured note products are anything but safe. To better understand this post, let’s try and first define a structured note. Perhaps the simplest definition is: “A structured note is a hybrid security that includes several financial products, typically a stock or bond plus a derivative. A simple example would be a five-year bond tied together with an option contract.”
Structured notes have so many variations that trying to describe every product on the market is impossible. By the time this post is completed, another product will have likely been launched.
Structured notes return to vogue whenever the stock market becomes volatile. When the market becomes unsettled, brokerage firms and promoters roll out these hybrids. Unfortunately, in our experience, few brokers can fully explain the products they are selling. If brokers don’t understand them, customers don’t have a chance.
Both the SEC and FINRA (the Financial Industry Regulatory Authority) have issued investor alerts about structured notes. They warn customers to fully understand the risks inherent in these investments.
First, there is the risk that the issuer of the note could go under. Depending on how these notes are structured, the payout could be quite large. If the issuer doesn’t have deep pockets, the note can become worthless.
There are also liquidity issues with these products meaning there is often no secondary market on which to sell your note. Buy one and you might have to hold on years until maturity.
Because these products are tied to the price of some other asset, the bigger risk is that the note itself may become worthless depending on what happens to that other asset. Notes that are sold as a hedge against the decline in the stock market can become worthless whether the market goes up or down.
Last week, the Wall Street Journal noted that the number of note offerings had more than doubled from the same time period last year. Presently there are 343 structured notes on the market. We are not surprised. After a relatively stable long term bull market, the stock market is beginning to swing wildly day to day. The market’s volatility index has soared and that sends promoters scrambling to develop new note products.
The Journal examined several notes presently on the market. A relatively new offering is one issued by Goldman Sachs and linked to the Russell 2000 index of small cap stocks. If the return on that index is between a 15% loss and a 25% gain as of the note’s maturity in January 2017, note holders would receive 20.9%. Sounds great… protection if the market drops yet still potential to earn money if the bull market continues.
There is just one flaw. If the index drops more than 15%, you lose everything. If small cap stocks surge and go above the index benchmark, investors simply see a return of their principal and no interest.
Yet another risk are the outright scams on the market. Volatile markets seem to encourage fraudsters who prey on investor uncertainty. Already this year the SEC shut down one structured note scam operated by James Erwin and Swiss based Malom Group AG. (If there was any doubt that the notes were a scam, MALOM allegedly was the acronym for “Make A Lot Of Money.” Unfortunately, Erwin’s investors made no money; they lost everything.)
If you fully understand the risks, structured notes may be worthwhile. As we noted before, however, many stockbrokers and investment advisers can’t explain them. While they tout “principal protection,” they don’t fully understand that many notes pay nothing under certain circumstances. If you choose to invest, make sure the promoter / issuer is a reputable company and make sure your broker fully understand how the investment operates. Understand too, the tax implications of the deal and if there is a secondary market for the notes. Nothing is worse than being stuck for years in a product that you can sell or liquidate.
Structured notes are generally for sophisticated investors. Stockbrokers have a legal duty to fully understand their client’s investment needs, experience and risk tolerance. They are also required to perform proper due diligence on the products they recommend and make sure they are suitable for each client.
If you purchased a structured note product or any other type of alternate investment and lost money, you may be able to get back your money from the broker or his or her employer. Most cases can be handled on a contingent fee basis and can often handled from start to finish in just over a year.