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By Guest Blogger Sinan Terzioglu
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The structured notes market in Canada has been expanding quickly, with some estimates valuing it at over $100 billion. The main attraction of structured notes is their principal protection, which safeguards an investor’s initial investment while allowing participation in the potential upside of an underlying asset.
Jim recently sold his business and asked:
After years of hard work and sacrifice, I’m very anxious about investing the proceeds from selling my business, which is most of my net worth, in the financial markets and potentially losing any capital. I know I must take some risk to potentially earn a higher return than GICs offer. My bank connected me with one of their advisors, who suggested I consider investing in structured notes. The notes he offered guarantee 100% capital protection while allowing participation in the stock market’s upside up to a certain limit. Although I don’t fully understand these products, they seem very appealing as they offer a guarantee against losses and the opportunity for a decent return. They seem like exactly what I’m looking for. What are your thoughts on these products?
The idea of investing with no risk and only potential gains seems too good to be true—and it is.
Structured notes are promoted as innovative financial products that combine bond-like stability with the potential for higher returns through derivatives. Essentially, they are debt obligations issued by financial institutions, with returns tied to the performance of an underlying asset, such as an equity index like the S&P 500 or a basket of stocks. Despite their appealing features, structured notes come with various risks and complexities that, in my opinion, make them unsuitable for most investors. Additionally, be wary of bank ‘advisors’ promoting these products, as they are essentially salespeople.
The payout formula for structured notes can be very difficult to understand, often involving various conditions and triggers that determine the final return. For example, some structured notes may offer a return if a specific index remains within a certain range but provide little to no return if the index moves outside that range. This complexity can lead to confusion and misinterpretation, increasing the risk of unexpected financial outcomes.
Structured notes are usually tied to price-only indexes, meaning investors only benefit from the index’s price returns without receiving dividends. Historically, dividends have contributed a significant portion of the total returns of equity indexes. For instance, dividends have accounted for approximately 40% of the S&P 500’s total returns over the long term, making them crucial for achieving strong total returns.
Additionally, structured notes come with several inherent risks such as:
Counterparty Risk: Since structured notes are debt instruments issued by financial institutions, their value is tied to the creditworthiness of the issuing institution. If the issuer defaults, investors could lose their entire investment. This is very unlikely with our big banks but the collapse of Lehman Brothers in 2008 is a stark reminder of the potential for issuer default.
Liquidity Risk: Typically, structured notes are not listed on an exchange, and there is no assurance of a secondary market for trading them. These factors often lead to potential liquidity issues, meaning your money could be tied up for the duration of the note. Issuers of structured notes might provide a secondary market and be willing to buy back or redeem notes prior to maturity, but likely at a significant discount to the face value of the note.
Call Risk: Some structured notes are callable meaning the issuer may redeem the note before its maturity date. This often happens when it benefits the issuer, such as when interest rates fall or the underlying asset performs well. For investors, this can mean losing out on potential future gains and having to reinvest the returned principal at potentially lower interest rates or less favorable conditions.
Structured notes often come with high fees and commissions that can diminish potential returns. These costs may include issuance fees, management fees, and broker commissions, making structured notes considerably more expensive than even the priciest mutual funds. As a result, investors in these products often end up overpaying for downside protection at the cost of potential upside.
In summary, the complexity and inherent risks of structured notes make them unsuitable for most investors. I believe that investors like Jim would benefit more in the long run by maintaining a balanced and diversified portfolio of low-cost ETFs that track global equity and fixed income markets. This investment strategy is likely to yield higher returns over time while offering capital preservation, liquidity, tax-efficient income, reduced risk, and unlimited upside potential. Essentially, balanced and globally diversified portfolios provide all the advantages promoted by institutions offering structured products, but without the complexity and high costs.
Sinan Terzioglu, CFA, CIM, is a financial advisor with Turner Investments, Private Client Group, Raymond James Ltd. He served as vice-president of RBC Capital markets in New York City and VP with Credit Suisse in Toronto.
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