Structured Notes Present Potential Benefits In Reduced Complexity, Fee Transparency And Potential Upside
Alternative investments are once again fashionable among investors and advisors. In 2022, asset managers Fidelity and BlackRock launched funds tied to alternatives as retail investors sought safety away from traditional assets and the traditional 60/40 portfolio fell under pressure, as noted by Goldman Sachs Asset Management.
This year, with steep stock and bond market losses and rising interest rates, there are many niche investments to consider. Unfortunately, high and opaque fees, capital lockups and uncertain creditworthiness of issuers are key risks that must be weighed before jumping into such products.
Still, with elevated equity volatility and fixed income returns correlated with the stock market, the appeal of alternatives is understandable.
However, classic alternatives are no longer the only game in town. Increasingly, savvy advisors and portfolio managers are turning to structured products to fine-tune investment portfolios. By offering both tactical potential and core, strategic allocation strength, structured products can make it easier to refine asset allocation strategies without abandoning conventional stocks and bonds.
More Choices, More Problems?
Performing due diligence in the alternatives space can be challenging – even before capital is put to work – due to the many options at the advisor’s disposal. This can create confusion, uncertainty and doubt as to what asset types are ideal for client portfolios. From crowdfunded real estate, to art, fine wine and farmland (to name a few), it’s difficult to find the time to research the many diverse platforms.
The recent surge in alternative investment platforms is dangerous because there’s uncertainty about how these nascent arenas will fare if a prolonged economic downturn or bear market should strike. In addition, once invested in alternatives, explaining valuation changes in sub-asset classes is a challenge for the advisor as it requires an understanding of what are often unique fundamental variables.
Advisors’ time is already constrained enough with managing a business, learning about new tax laws, cultivating relationships and navigating a tough investment environment.
Structured Notes As A Simple Solution?
Structured notes are hybrid securities that contain a bond component (roughly 80% of the product) and an embedded derivative, such as a call or put option (20%). These protective investments contain four parameters:
- Maturity: The term can range from six months to 20 years but is usually two to five years
- Payoff: The amount the investor receives at maturity
- Underlying Asset: The note’s performance is linked to the price return (excluding dividends) of an asset, such as stocks, equity indexes, ETFs, interest rates, currencies or commodities
- Protection: The level of protection the investor receives if the underlying asset loses value
With structured products, you are less likely to stress about explaining a mediocre performance period as you might with some other alternative investments.
Instead, a structured note is commonly priced on an underlying index like the S&P 500 and offers a specific downside protection amount with defined upside participation. Those terms are stated and described with clarity on the note’s prospectus.
Increasingly, platforms are making structured products more accessible. Many alternative and structured product platforms include a robust suite of educational resources, which can help advisors come up to speed quickly.
Knowing What Your Alts Cost
If you understand how the stock and bond markets work, you can understand how structured products are priced. These are not esoteric assets like many investments in the “alternative investment zoo” can be. What also makes structured notes stand out is that they have clear and transparent fees.
Many emerging “alts” are simply vehicles for investment managers to collect high fees in a world of falling brokerage margins and near-zero-percent fund expense ratios. With any alternative you research, knowing exactly the price you are paying along with any other special account charges is imperative.
An Eye On A Market Recovery
Along with feeling uneasy with many alts in today’s financial world, focusing on the long haul is sometimes a challenge when investing in typical alternatives. Investment managers are known to “fight the last war,” and choose an alt that performed exceptionally well during a previous downturn.
Once a new bull market begins, though, the investing regime has shifted and the strategy might go on to deliver weak returns. By contrast, structured notes offer participation in the market’s upside so that clients are positioned to take part in a possible rebound. With most other alternatives, you’re at the mercy of whatever idiosyncratic factors are at play.
Flexibility And Non-Correlated Returns With Structured Notes
Structured notes offer flexibility so that an advisor can tilt a portfolio for a certain market outcome. What’s more, today’s technology has brought costs down so that the typical transaction might cost as little as 20 basis points. The overall goal is usually to have some exposure to an underlying asset, but in a risk-controlled way that protects against volatility.
The same benefits can exist in an emerging fund type that has seen impressive flows in 2022 – buffered ETFs. These funds can be a liquid alternative to structured notes.
The Bottom Line
Structured products can be thought of as “the alternative to alternatives” because they can deliver uncorrelated returns, high yields, flexibility and customization, all with transparent and often low fees. Keeping complexity in check helps clients understand their portfolios, which builds confidence so they can stick with it during good times and bad.