Structured Notes:
An Alternative Product that Curbs Risk while Maximising Return
As an investor you may not have a very high risk appetite; yet, equally, you don’t want your money sitting around doing nothing. The question is where and how to invest when confronted with the almost bewildering array of products and markets to choose from, many of which may fail to provide the returns your were hoping for.
The answer may lie in an investment type known as a structured investment, or commonly referred to as ‘structured notes’.
People who wish to invest their money usually look for two things: firstly, protecting their wealth, and secondly, generating reasonable growth. However, for many people the two don’t always seem to go hand in hand.
You could, for instance, invest directly in stocks, where the risk can be extremely high. Or, if you have neither the stomach nor the expertise required, there is the mutual funds and unit trust route – probably the best known and most popular – where investments are pooled, invested in stocks and bonds, and managed by professionals. However, while we are often promised less risk for more return, it usually comes at a hefty cost and does not often provide the returns we had hoped for.
The other alternative is simply to leave your money on deposit with a bank where your risk will be minimal, but your money will most likely lose value.
What if you wanted to pursue a middle option: an investment vehicle that combines the safety of a bank deposit account with the anticipated growth associated with exposure to the equity market?
Even better. What if you could do so through a respected and trusted institution; have such an investment vehicle worked out for you and managed professionally, with your money invested in one of the ‘safe’ G3 currencies, and you could predetermine the parameters of the return you wish to receive on your investment?
This is where structured notes enter the picture. Because of their technical complexity and institutional nature, an investor will need the assistance of an offshore platform and an independent financial adviser to gain access. For people resident in African countries such as South Africa or Zimbabwe, a structured note programme with a specific African focus backed by a large offshore bank is available.
Tailored to Your Needs
The structured note is relatively new to the marketplace, having gained in popularity only over the last 25 years or so, appearing in the UK, for example, only during the early 1990s. But structured notes have already proven their worth over and over as an ideal investment vehicle for high-net-worth individuals, discretionary trusts, a variety of institutional investors, family offices, or holders of a UK pension in a QROPS scheme (Qualifying Recognised Overseas Pension Schemes), amongst others.
For high-net-worth South African residents structured notes offer an excellent offshore investment opportunity.
In a nutshell, a structured note is a tailor-made investment that typically combines exposure to the financial markets with predefined returns linked to an underlying asset. These returns will typically have a deposit element that may offer partial or total protection of the capital invested, explains Emma Davidson, who heads up the Carrick Wealth Note Programme based in London.
The financial options involved are often referred to as ‘derivatives’ because their value is derived from the underlying asset which may be linked to the performance of stock market indices, interest rates, currencies, commodities, combinations of these, and more.
Over time, as the market developed and matured, structured notes have come to be designed specifically for investors who want the combined benefits of maximising their potential returns through access to major equity markets, while reducing their risk and protecting their wealth.
Why Not Stay with Mutual Funds and Trusts?
You may wonder: why not simply stay with mutual funds or investment trusts which have been around much longer?
For those less familiar with all the intricacies of the various investment vehicles, mutual funds and trusts, known as Collective Investment Schemes (CIS), are, simply, investment holding structures that are funded by their shareholders – the investors – and which trade in diversified holdings and are professionally managed.
For some people mutual funds and other CIS programmes may be the right solution. They are accessible to everybody; don’t require mountains of cash and are professionally managed by experienced fund managers. For others, especially for high-net-worth individuals seeking to maximise and predefine their potential returns whilst limiting the risk involved, structured investments may be the better option.
At Carrick, we don’t believe our clients should have to choose: we believe they should have access to both.
Collective schemes – which in South Africa includes the well-known unit trusts, known since 2002 as ‘collective investments’ after changes in legislation – have become a very popular form of investment. Each investor has a stake – and return – in the CIS portfolio proportional to how much money the investor contributed, which is what the word ‘unit’, or now called ‘participatory interest’, refers to. The shareholders receive money through a distribution of dividends or interest gained and can also earn profit should the value of shares increase and then be sold.
While there has been a phenomenal proliferation of mutual funds over the years, the question is whether they actually give investors the returns they had been promised or hoped for.
Emma believes that the vast majority do not. ‘Transaction fees, hidden expenses tied to administration and advertising, as well as under-performing fund managers are all taking their toll on investor capital,’ she says.
This is despite their popularity being underlined by the 2014 Investment Company Fact Book which shows the global mutual fund industry had US$30 trillion worth of assets invested in it in 2013. And the Ernst and Young (EY) Global Wealth and Asset Management report also stated that mutual funds had reached an all-time high in 2013.
The Standard & Poor’s Dow Jones Indices Versus Active (SPIVA) report shows, however, that 86.44 per cent of US large-cap fund managers failed to deliver the returns they promised over the benchmark in 2014. And a 2011 Forbes article calculated that a non-taxable mutual fund account accrued costs of 3.17 per cent per annum, rising to 4.17 per cent when taxed.
Is There a Downside?
Structured notes have often received negative media attention and sometimes for good reason as there are many inappropriately structured note investments in the market, and some that are sold misleadingly. In fact, mega investor Warren Buffett infamously labelled them as ‘financial weapons of mass destruction’. And some would say they are too complex and ‘too expensive’. However, whether Mr Buffet was quoted out of context or did not really mean what he said, his own Berkshire Hathaway portfolio profited from derivatives gains of US$4.3 billion in the 2013 financial year, it has been reported.
And while the industry was still finding its feet when Lehman Brothers collapsed during the 2008 global financial crisis, like any other industry it also had its share of bad apples. But the negative stories have been the exception rather than the rule, and since the inception of structured notes, the positives have far outweighed the negatives. Besides, all investments types are vulnerable during crises such as that of 2008.
Unfortunately, because structured notes are still relatively new to the market, there are many senior managers and advisers who have very little knowledge of them and, rather than admit to the fact, will try to steer their clients away from them altogether.
Considering these issues, it is all the more reason why it is imperative to consult a reputable, experienced and licensed independent financial adviser with a good track record in this field.
Since the 2008 crisis, there has been a comprehensive overhaul of how risk is assessed across many asset classes, including structured notes. Structured notes have themselves been improved with new features added and they have come a long way since then…with good results.
They remain very popular. For instance, the Bank for International Settlements calculated there were US$690 trillion worth of outstanding over-the-counter derivatives traded as of December 2014, although predominantly in the institutional wholesale sphere with large investors like Warren Buffet, for example.
How Can You Benefit From Structured Notes?
The Carrick Note Programme was developed specifically for high-net-worth clients resident in South Africa, or elsewhere in Africa. The programme has an exclusive agreement with the Royal Bank of Canada (RBC) to distribute structured products via life companies in Africa.
While the RBC may be relatively unknown to some given the bank’s preference for maintaining a low profile, not only is it domiciled in a AAA-rated country where it was founded in 1864, but it is also the largest bank in Canada and the 12th largest bank globally – based on market cap. It operates in 41 countries and employs 78,000 people worldwide. The bank is a Top 5 global asset manager by assets, and currently has assets of US$1,086.7 billion and deposits of US$654.7 billion. It serves more than 16 million clients globally and has been rated AA by Fitch Ratings, Aa3 by Moody’s and AA by Standard & Poor’s.
The most important risk to consider in a structured note is the creditworthiness of the deposit holder. In a low interest-rate environment, some banks may often use sub-ordinate debt as the credit promise, or, alternatively, the credit provider itself may not be very creditworthy. Large institutions such as the RBC have the highest deposit rating. The higher the rating of the depositor, the higher the security of the money being held. The most important aspect with structured notes, therefore, concerns the choice of the institution providing the promise.
Structured notes are tailor-made in conjunction with banks such as RBC and participating life companies. For reasons of political and financial security, geographical considerations and ease of access, they are best nominated in one of the G3 currencies – euro, US dollar and the pound sterling. Pound sterling is, however, often the first choice because of the United Kingdom being a AAA-rated country and because of the pound’s proven ability to maintain its integrity even through turbulent economic times.
‘Structured investments allow clients to benefit from predefined terms that can deliver positive results over a range of scenarios. The right partner will act as a guide that can structure a bespoke offering, handle key administration needs and negotiate the best terms with issuers,’ says Emma.
In addition, much lower fees are applicable than in the case of many other investment vehicles as various middle men are excluded. Partnerships of choice are typically with family offices, discretionary fund managers, private banks and high-net-worth professional investors.
Thus, in essence, a structured note is a predetermined, mutually agreed-upon promise from the issuing bank based on a legally binding contractual obligation that it will deliver a return to the investor defined as certain pay-off scenarios, given certain market events, based on the performance of the underlying assets. Every note is structured individually with different conditions and time frames.
How Does One Invest in a Structured Note?
A structured note is an institutional product which can only be purchased by an individual via an institutional wrapper – that is, though a life company. An ‘institutional wrapper’, or portfolio bond, is an investment platform through which the investor can purchase a variety of investments, including structured notes. Structured notes are tradable securities, much like a tradeable share on the stock exchange.
On the client’s instruction a life company such as Sanlam or Old Mutual, for example, will then go to the depositor bank and deposit cash in return for the predefined set of outcomes within a future time frame. While each investment is demarcated individually, the total amount invested by different investors is then used collectively to purchase the note.
The parties agree on a specific, predefined return which can either be paid out or rolled up based on the performance of the underlying assets which, as mentioned, can be indices, stocks, commodities or other financial instruments. There is an agreed level of protection of the capital invested which can range from between 20 per cent and 60 per cent, or even higher. If capital protection has, for example, been set at 40 per cent, the issuing bank undertakes to return 100 per cent of your capital provided none of the indexes fall below 40 per cent. If the underlying indexes fall by more, the investors starts losing capital on a one-for-one basis. In other words, if the indexes are down 41 per cent, the investor then loses 41 per cent of the invested capital.
It is important to remember that no investor should enter into the financial markets if they believe that the underlying they are exposing themselves to could fall by more than the protection level (in this case 40 per cent) over the investment period (five years in most cases).
While the wholesale notes are not regulated in SA, the participating life companies purchasing these notes on behalf of client’s are. These life companies have strict criteria concerning which banks and which notes they can and will accept.
Images courtesy of the online media library of the Royal Bank of Canada.
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