Every once in a while something sexy comes across my desk. Structured notes that claim to make money in an up or down market that will draw the attention of anyone feeling week or looking for a quick distraction over lunch. I love to read this stuff. Maybe there is still that little kid in me that thinks there is an option fairy that will leave money behind if I only believe.
This week another set of Twin Win Notes, issued by Societe General will be priced and sold to less savvy investors. The pitch? You can get the upside of the market if the SPX goes up. You get paid if the market goes down. Right there most people will stop listening and just say buy it. But the devil is in the details and I want to go through an example to show you why this can go all wrong pretty fast.
First, let’s talk about how these are sold to the general public, and keep in mind UBS just paid $19.5 million to settle false and misleading statements and omissions selling overly complex structured notes to unsophisticated retail investors. Read the SEC’s press release here. A broker calls you up and says they have a magic note, debt issued by Society Generale, that credits interest not based on interest rates, but on the movement of the S & P 500 Index, or SPX for short. They may not mention the dividend yield is not included, since this is needed to pay for the hedges the note provides. So, at the very start this isn’t a substitute for an index fund that tracks the index like SPY that pays a dividend you can either take in cash or reinvest as you see fit. Getting back to the pitch, you are given a few cherry picked scenarios. At maturity, if the SPX (in price only, not the total return after dividends) is up 30%, you receive 130%. If the SPX is down 48% (this is the very edge of the lower bound I will explain in a moment), you receive 148%. If the SPX is down 50%, just 2% lower than a 148% payoff, you receive only 50% of your initial investment.
Come on! Wasn’t there a clue right there? If 6 years from now the total price return of the SPX is down 48% you get 148% return, but if it is down 50% you get 98% less and lose half your money? Do you feel this seems more like a parlor trick of some bet you would read about in a Michael Lewis book? Just remember that you are buying a bond linked to derivatives. While I can say it as simple as buying an underlying index, then buying and selling a few put options, it’s a little more complex than that.
Second big idea outside of how they are sold as head you win tails you win, is that they don’t protect your principle. If over the observation period of 6 years, the SPX declines more than 48%, you get “knocked out.” That is a fancy name for all bets are off. At that point, no matter what happens to the SPX, at the end of the 6 years you will get the performance, minus dividends, of the SPX, good bad or ugly. I get it. What are the chances of the SPX going down more than 48% over the next 6 years? Not huge, but we simply don’t know that today. Thus, we are buying a complex structured note that right off the bat makes us comfortable and greedy by the promise of a payoff even if the market is down years from now. So why not take a shot?
That leads us to the third and most important point. What is your motivation? See how this product seems to promise different things to different people? I would venture to guess it is designed to appeal to multiple emotions of the same investor. Here are the profiles that is not right for, in my opinion.
I want more yield!
We always look for bond substitutes for cleint’s in a low yield environment. However, the protection of principle is a key feature we seek when going off the basic stock bond allocation. I love a principle protected note or annuity that can have an alternative crediting reference rate like the SPX. But I still need the principle protection. This doesn’t do that if things get too crazy in the market over the next 6 years, even it that period is over quickly like a flash crash. If you want to trade your safer bond assets to take the risk of the market providing your interest crediting, make sure whatever that product is still protects your principle no matter what that underlying index is. If not, why bother?
I am bullish on the market!
Then buy a cheap index fund and push the factors that create higher expected returns. Why would you lock up your money in a structured note for years, get a bad tax treatment (remember this is debt and treated as current income, not long term capital income), and not even collect dividends? If the market is flat during the 6 years, you could have at least collected dividends versus a 0% return if the price of the index doesn’t change.
I think the market will go noplace!
This is the worst thing you can do. If the market is flat – the return is 0%. Remember you have to see the SPX move up or down to get a positive return. Just not too much on the downside or you are at the whims of the market. So, it doesn’t make you money in a flat market.
I want stock exposure but less risk!
STOP! That is great! We all want that. The most efficient way to do that is have a balanced portfolio of stocks and bonds. You get all of the benefits of diversification and asset allocation, but with less risk since you mix in bonds to reduce volatility. What is even better is you can rebalance over those years to sell stock when it becomes to large a part of the portfolio. You sell stock and buy more bonds. When stocks drop and bonds are too large in your allocation, you sell bonds and buy stocks. What a nice way to naturally buy low and sell high!
The bottom line is that there are more effective ways of expressing our fears and hopes for the market without locking up your money in a complex vehicle that in the end won’t protect principle. Don’t get me wrong, our firm loves to look at alternative strategies that increase cash flow, safety of principle, and improve performance for our more conservative investors. However, we prefer to look at an annuity that guarantees principle and can provide cash flow if we are going to stray away from plain vanilla globally invested stock and bond portfolios.
The Twin Win notes are 6 years long. Right off the bat that seems like a long time to have a complex set of rules to be locked into. Simply