Alternative Investments

Structured Notes Are Attracting Interest—and Controversy

Over the past few years, a range of institutional-style investment approaches have moved into the mainstream. Private equity, private debt, infrastructure funds and other alternative investments—the kinds of asset classes that were once preserved for hedge funds and their clients—are now being widely adopted by financial advisors and their clients as well. 

Structured notes (which also go by the name “structured investments”) make up the latest asset class that is seeing growing demand from advisors for use in portfolios of “mass affluent” investors. These investments typically serve one of two goals: Enhanced interest income compared to traditional bond funds; or as a vehicle to provide a degree of downside protection during periods of stock market weakness.  

In recent weeks, access to structured notes has been made easier as new analytics tools, education modules and trading platforms have been rolled out by leading fintech providers.   

In mid-November,


Envestnet

and Simon Markets announced the launch of a platform that will serve as a sort of one-stop shop for structured notes for fee-based advisors. 

Structured notes appear to be an ideal solution for advisors that are concerned about elevated stock prices or paltry fixed income yields, but have some drawbacks.


Illustration by Brian Stauffer

Chicago-based Envestnet provides software and services to more than 100,000 advisors and more than 90 percent of the nation’s top wealth management firms and brokerages. New York-based Simon operates a suite of education, portfolio modeling analytics and trading tools to more easily deploy structured investments within client portfolios.

“The partnership enables us to help advisors to weave the asset class into various portfolio models in ways that could only be done before at the institutional level,” says Jason Broder, chief executive officer of Simon. “They can find the right level of allocation for the notes as part of a broader portfolio framework,” he adds. Advisors, for example, can see how portfolio risk and return would be impacted by the addition of these notes to a stock-and-bond portfolio. 

The analytics tools can help advisors assess key factors of a structured note such as upside potential, downside protection, liquidity, simplicity and the underlying history of the note. 

On the heels of the Envestnet/Simon platform launch, Fidelity Investments announced similar plans to partner with Simon, which will serve Fidelity’s client base of 13,500 wealth management firms. 

Growing market. Clearly, these firms are skating towards the puck in hopes of what may become a sizable asset class. SIMON’s Broder estimates that the structured notes market has surged in value from $60 billion in 2019, to $74 billion last year to an expected $90 billion this year. 

At first blush, structured notes appear to be an ideal solution for advisors that are concerned about elevated stock prices or paltry fixed income yields. In the event of a sharp market drop, structured notes can soften the blow in a downturn. A note, which is a hybrid security that pairs index options to a promissory note, often includes a guarantee of a return of principal. 

As an example, a note focused on the S&P 500 that protects principal against a 25 percent drop, would leave the client’s investment whole if the index fell only 20 percent during a specified period. They can be structured to mature anywhere from six months to 20 years, though most mature between two and five years. Upon maturity, the investor also sees a return of principal. 

Then again, if the S&P rises more than the capped amount in the period (for example 10 percent), the client will have left any upside above that amount on the table. 

Other structured notes, known as “income notes,” often provide rates of return well in excess of plain vanilla bonds. Ken Nuttall, chief investment officer at New York-based BlackDiamond Wealth, says that structured notes can generate yields of nine to 10 percent “as long as the underlying index doesn’t fall sharply.”

That’s no small caveat, though Nuttall adds that these high-yielding notes “if properly structured, don’t carry much more risk than high-yield bonds but pay much higher yields.” However, either asset class may be tarnished in a sharp recession and attendant market drop.  A client’s liquidity needs should be considered, as structured notes can’t be easily cashed in on a moment’s notice. “They can be especially well-suited for retirement accounts due to typically lower liquidity needs in those accounts,” says Nuttall, as those accounts typically are invested for the long haul. 

Hunt for yield. Dana D-Aria, co-CIO of Envestnet says that her firm’s platform is “seeing a lot of demand from advisors in the yield enhancement segment of the market.” She adds that her firm plans to add structured note analytics into Envestnet’s platforms such as MoneyGuidePro.

Advisors need to deeply research all of the features of structured notes such as market risk, liquidity and call provisions and the fees spelled out in the contract. Even after all of that due diligence, Nuttall makes clients “sign a disclaimer that they understand the risks and benefits” of the note.

Despite their various benefits, structured notes also carry some key challenges, leading some advisors to shun them after performing due diligence. Charles Sachs, the chief investment officer of Miami, FL-based Kaufman Rossin Wealth, LLC, likens structured notes sales pitches to the kind typically put on by annuity salespeople. “Advisors and clients hear a lot about the upside and very little of the downside,” he says, adding that they are “somewhat like a parlor trick.”

As an example, “you can leave a lot of upside on the table when the markets are sharply rallying over a specific period,” says Sachs. He says there are simpler ways to protect against market downturns. “If you want to mitigate risk, then have less equity exposure,” he says. 

Drawbacks and risks. Many structured notes offer somewhat limited downside protection. Sachs suggests that if a note is structured to protect against a 10 percent drop in the index, and it falls 35 percent, investors are still looking at a 25 percent loss. 

Of greater concern, “these are very high-priced products,” says Sachs, adding that “retail notes (which are typically much smaller in size than institutional-sized notes) tend to have opaque fee structures that are often not well spelled out.” Those fees often end up eating into returns. “It’s just financial engineering and the cumulative drag on returns can really add up,” concludes Sachs. 

Lastly, Sachs expresses concern that due diligence on structured notes can be quite a challenge. Even after reading a prospectus that can approach 200 pages,“ he still has “a hard time figuring out exactly what’s going on.”

If you Google the term “structured notes,” you’ll see a range of cautionary articles that explain why this remains a controversial asset class. There are numerous examples of structured notes that did not provide either the downside protection of enhanced income they were designed for. This was usually the result of a note that was pegged to a volatile stock or niche index. Fewer such outcomes happen when notes are based on a major index such as the S&P 500. 

Nuttall, who remains a proponent, concedes that it is important to gain access to larger structured notes, since fees drop as the size of the note increases. “We’re always willing to partner with other RIA firms to have greater buying power,” he says.

While structured notes have historically been a challenging asset class for advisors to understand, the education and analytics tools now being offered by firms like Envestnet, Simon and Fidelity are helping to shed greater light on their impact on portfolios. 

David Sterman is a journalist and Registered Investment Advisor.  He runs Huguenot Financial Planning, a New Paltz, NY-based fee-only financial planning firm. 


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