WALL STREET GIBBERISH, 2016 SECOND QUARTER NEWSLETTER

I use this occasional section to expose things such as articles, pronouncements, and investments that are technically correct, but may be harmful to one’s financial well being. This time it is more of a warning than typical gibberish. The warning is to beware of so-called “structured notes” and do not invest in one if you do not understand how it works and what it will return in all possible market conditions.

Structured notes are typically available from investment banks and full service brokerage firms. The main selling point is that they guarantee a specified minimum return and the opportunity to participate in gains in the stock market or by commodities, either a specific one such as gold and oil or a basket of several. The guarantee is not by the government but depends on the solvency of the issuer. Usually this is not a concern because the firms that issue them are almost always large and well capitalized. However, Lehman Brothers fit that description for most of its history before going under in 2008.

It is not unusual for the notes to require owning them for several years before the guarantee takes effect. Early withdrawal usually involves penalties and invalidates the guarantee. There is no market for them, so one is forced to deal with the issuer under the terms it has established. One example I saw guarantees a return of the original investment after five years. While there is no loss per se, if inflation is at 1.5% a year over the period, getting back what was paid in is a reduction in purchasing power of 7.3%.

How can an investment company guarantee a minimum return, which is usually positive, and provide participation in market gains? The methods can be fairly complicated, but there are simple ones that could be done by individual investors with more than minimum size accounts. One way would be to buy a Treasury bond that has had its “coupons,” the future semi-annual payments, stripped off, a so-called zero-coupon bond. These sell at a discount from face value because they do not pay interest (but there is "imputed interest" subject to taxation in a taxable account), and will rise gradually in value until they mature at their face value. For example, say one can buy a zero-coupon bond due in ten years for about $82 per $100 of face value, which would be about a 2% compound annual return. The remaining $18 could be used to buy a stock index fund, or more aggressively, used to buy call options or futures on stock indices.

As in the example, a portion, which may be substantial, of the investment is used to pay for the guarantee. Consequently, the participation in the stock market may be muted, unless options or futures are involved, since not all of the note is put into the market. Worse yet, the terms are often quite complicated and misleading.

I recently saw an example of one that is especially confusing and quite unlikely to meet a typical investor’s expectations. It is issued by a major investment bank. The note has a placement fee of 3.5% because the issuer wants to make sure of making money on it. It guarantees a 6% return over 6 years, but not all of the investment goes into the note. After the fee is paid, $1,000 would return at least $1,060, which is a compounded annual return of a little less than one percent. A higher return depends on the performance of the S&P 500. One might expect that if the index was up 10%, 20% or more over the six years that a lot more than the minimum would be paid back. However, there is a sneaky trick involved so the market’s compounded returns over the period are not used to determine the pay out, but the sum of the quarterly returns. Even worse, the up quarters are capped at 4.5% in calculations, but there is no limit on the down quarters. A study of how this would have worked over 58 quarterly rolling six-year periods between 1994 and 2014, showed that in 48 of them only the minimum would have been returned. Only the earliest of these would have had a return that exceeded the 3.5% placement fee, and the more recent ones would not have come close.

The lesson is before investing in anything that is complicated—variable annuities are another example—be sure you understand all the ins and outs and details. In particular, what happens if you want or need to sell or get out of it before a minimum holding period? My rule of thumb is that I don’t want to invest in anything that doesn’t have a price available online and that I can’t buy or sell any day the market is open. That does not mean that structured notes or variable annuities should be avoided by all investors as they may be suitable for some. However, be suspicious of any that are promoted as can’t miss. One test is to find out who is making money if you buy it, how they make it, and what is their real interest in having you buy it.

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