Many fiduciaries have greatly expanded the types of investments they use in portfolios, thanks to the freedom afforded by widespread adoption during the past two decades of both the Uniform Prudent Investor Act and the Uniform Principal and Income Act. Whereas portfolios typically were invested almost exclusively in stocks and bonds previously, today’s portfolios frequently add commodities, foreign currencies and a variety of other investments to the mix. (See “Today’s Trust Portfolios (a Sample),” this page.)
Among a fiduciary’s current prudent investment choices, structured products can serve an important purpose. In the right circumstances and handled properly, these strategies—also known as structured investments, structured notes or just “structures”—can increase return and reduce risk. In other words, structures are a potential opportunity about which the well-prepared fiduciary should be aware. (See “What’s a Structured Product?” p. 49.)
There are many different types of structured products. To see how they work, we’ll illustrate the buffered return enhanced note (BREN), one of the structures most widely used today. (See “Sample Payout Diagram,” p. 49.)
In this example—a BREN based on the S&P 500 index—the structure:
• Has a 54-week maturity; the payoff is based on the change in the value of the index from the date of purchase to maturity;
• Provides twice the price return (excluding dividends) of the index up to a capped maximum return; and
• Protects investors against the first 10 percent of loss should the index fall over the life of the note.
If the market goes up, this BREN provides twice the index’s return, up to a cap. Let’s say that cap is 6 percent. If the market is up 4 percent from purchase to maturity, the note would pay 8 percent at maturity.
The maximum return of this BREN is 12 percent (twice the 6 percent cap). Should the index appreciate more than 12 percent over the note’s life, the structure would underperform a comparable investment in an index fund or exchange-traded fund (ETF).
If the market drops, the “buffer” helps protect the investor on the downside. For example, if the structure has a 10 percent downside buffer and the index drops less than 10 percent during the year, the note at maturity would return all of the capital invested.
However, if the market should fall more than 10 percent, the investor would experience a loss of capital. In fact, the protection provided by the buffer decreases as the market falls. In particular, the capital loss is calculated by multiplying any drop in the market in excess of 10 percent by a leverage factor of 1.11. So, for example, if the market were to drop 30 percent over the life of the structure, one would subtract the 10 percent buffer and then multiply the remaining 20 percent loss by 1.11, meaning, at maturity, the investor would have lost 22.2 percent of invested capital.
This arrangement means that there’s a potential for investors to lose 100 percent of their invested capital if the market were to go to zero (the buffer having been completely eroded by the downside leverage). However, it also means that returns generated by the structure have the potential to be treated as capital gains/losses for tax purposes, as investors have put 100 percent of their capital at risk.
In short, this BREN enhances returns when the market is up a moderate amount and softens the downside risk, but underperforms in strong bull markets.1
Structured products have the following potential benefits:
Enhance returns. First and foremost, structures are used for their potential to enhance the expected returns of an underlying market, such as the equity market. Investors who think markets will trade sideways or even fall could use a structure with a buffer and a coupon that pays even when there’s a moderate drop. Investors who expect a modest rise in markets could add leverage to try to boost returns. Even investors who expect strong returns from equities could use structures; however, they would add leverage without a downside buffer so they may increase the maximum return. Very
optimistic investors might even use structures that give an uncapped return.
Dampen volatility. Buffers dampen the volatility of a structure relative to a similar investment in an index fund or ETF. When building an equity allocation in portfolios, any investor—particularly fiduciaries—should consider including structures alongside mutual funds and ETFs. The latter two investments can provide uncapped upside in the case of a strong market rally (as we saw in 2013), while structures can provide some protection from a selloff and enhance moderate returns with coupons and leverage.
Provide unique access. Structures can provide unique access to markets. For example, imagine an investor who wants to buy European equities but believes the Euro will depreciate, thereby eroding the return of any investments in that region when Euros are translated back into U.S. dollars. That investor may want, as part of the portfolio, a structure that provides the returns of the EURO STOXX 50 index of the Euro zone’s 50 largest stocks with the currency risk removed from returns.
By using a structured product, that investor also may be able to allocate funds to assets, such as commodities or foreign currencies, that are otherwise difficult to hold as direct investments.
Too Good to be True?
How is it possible for issuers to construct structures with features that are so attractive to investors? What’s in it for the issuer?
Issuers use the capital invested in a structure to take positions in derivatives, as well as the underlying assets, to mirror the note’s payoff. This is, therefore, NOT a zero-sum game, in which the issuer loses if the investor wins and vice versa. Rather, the value of the combination of derivatives and underlying assets held by the issuer should match the payoff of the note at maturity, thus hedging the issuer against market movements and funding the payout to the investor. The issuer earns a fee from packaging the components that go into a structure.
In addition, structures typically don’t pass through to investors any interest or dividends paid by the underlying assets. Issuers use that foregone cash flow to help provide more attractive terms to the note.
The terms of a structure—otherwise known as “pricing”—depend on a number of variables. The price is represented in elements, such as the level of the cap and size of the buffer, and they vary over time. In our example, the pricing of the BREN, which is represented by the cap and maximum return of the structure, is different from week to week.
A structure’s terms usually improve, and the maximum return is higher, when the expected volatility of the underlying asset increases (meaning there’s greater uncertainty about the future). Conversely, low expected volatility usually goes hand in hand with less attractive pricing.
Prices for structures tend to look most attractive after periods when the market sells off—making structures an effective way of entering an uncertain market with larger buffers and higher potential returns than in bull markets. This is the case because volatility increases with uncertainty during a bear market. Of course, those are the same times that many investors, particularly fiduciaries, tend to be most uncertain about their investing approach.
Structured products are criticized for their long lock-up periods, costs of exiting before maturity, complex payoff structures and potentially high embedded fees.
Investors, therefore, should carefully consider the tenor of a structure, assess the complexity of the payout favoring structures with relatively simple terms and scrutinize embedded fees. A reasonable fee level is generally considered to be about 1 percent per year, akin to those paid on some mutual fund investments. (See “Six Best Practices for Investing in Structures,” p. 51.)
It’s also prudent (depending on the size of any structured product held in isolation or as part of an overall portfolio), to invest across a number of different issuers, so as to avoid a concentration in one financial institution (just as one would diversify issuers in a bond portfolio). Fiduciaries also are well-advised to price structures among a number of institutions, to help ensure they get competitive pricing.
Trustees and investment managers should review the terms of the governing trust instrument before investing in structured products, to ensure the trust agreement doesn’t prohibit using structures or derivatives.
Any investments in structures also should make sense in the context of the trust’s duration, as well as its distribution and the overall diversified investment portfolio objectives.
Structured products may not be appropriate for all trusts. They have a degree of risk that may not be suitable for some trusts.2
In addition, when trusts need to generate traditional fiduciary accounting income, structures are less attractive, as no dividend or interest is paid during the term of these investments.
Trustees also should carefully consider any liquidity requirements; although, as many trusts have a long-term duration, liquidity is often less of a concern.
And, of course, trustees should check the applicable state laws to ensure that structured products are appropriate for trusts sited in their jurisdictions.
That said, a thorough and thoughtful analysis of structured products can be very worthwhile for trustees empowered to focus on total return. Investment opportunities such as structured products can play a vital role in a prudent trust portfolio that’s working to meet the needs of both current and future beneficiaries.
1. It’s important, before investing in any specific structured product, for investors to review the accompanying prospectus and any prospectus supplement to understand the terms and risks associated with that particular product.
2. Risks include: potential adverse or unanticipated market development; issuer credit quality risk; counterparty or issuer default; uniform standard pricing; adverse events involving any underlying reference obligations, entity or other measure; high volatility of risk of illiquidity; and little-to-no secondary market.