Caravel Partners

Structured Notes

October 22, 2024
Benedict Carter
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Structured notes are complex investment products with returns linked to an underlying asset. They are often marketed based on high coupon yields, downside protection, or some combination. The payoffs of structured notes can seem like a free lunch, but banks are not selling them to you because they’re your friend. When you’re having dinner with lions you have to make sure you’re at the table, not on the menu. Structured Notes should be avoided nearly all the time by nearly all investors and here we explain why:

They are difficult to understand

Here is some of the jargon you will have to learn to navigate. Just to take a very few at random: principal protected, autocall, kick-out, observation date, tenor, underlying. And on and on and on. You think your Advisor understands all this? He doesn't. You understand all this? You don't. What is complicated to understand you should avoid.

Crucially, the risk/reward profile is poor

Why would you invest in an instrument where the upside is linked to a limited set of underlying targets ( .. IF these assets go up by XYZ then ....) totally outside anyone's control while accepting a downside that may well be unlimited?

Lack of Transparency

The fact sheets for these Notes always emphasise the best elements while omitting or downplaying the disadvantages.

High Cost

A bank account, a money market fund, a bond or specialist protected funds give you just as much, or much greater protection, at much lower cost. And for a growth SN, you can buy the underlying indices or stocks similarly, at a much lower cost.

Lack of investment flexibility

Markets can fall of course but just as often quickly rise. If you are locked into a Note, you are effectively out of the market with that money and can miss the growth of the upswing.

Very limited liquidity

There is little or no secondary market for Notes. So being locked in when there is a need for liquidity is something SNs have no solution to.

My Personal Moan

In addition to all the above reasons, Structured Notes are a money management cop out. If your Investment Advisor is using the main asset classes for you effectively, you simply don't need to use Notes at all.

But is he able to? THAT is the real question.

Conclusion

Others hold different opinions but never have I seen any counter-argument that held any weight, with ONE exception – there is an argument for using Notes when (i) they are extremely defensive in nature and (ii) are structured over one year, maximum two. Then the costs are much lower and they can then have a place in a Defensive or a Cautious Strategy.

And the lower costs are exactly why so few of these short-term, defensive Notes are offered – because the commission is also lower or zero. Which proves the point.Fundamentally ... Structured Notes are about bank and broker commissions: that's the bottom line.

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