By Ryan Farias, Senior Portfolio Manager:

In the financial landscape, structured notes have gained considerable traction, particularly among clients eager to feel sophisticated and exclusive in their investment choices. Marketed mainly by prestigious brokerages like Morgan Stanley and UBS, these complex financial instruments, often embedded with derivatives and intricate payoff mechanisms, can easily extract a sense of elitism from those who invest in them. However, digging deeper into what these products really offer can reveal a less glamorous reality.

Consider a recent offering:  The 3-year Auto-Callable Contingent Interest Note, touted for its eye-catching 13% annual interest rate. At first glance, it shines like a beacon of opportunity. However, the catch lies in its intricacies. The underlying index, the U.S. Large-Cap Vol Advantage Index, aims to deliver a dynamic, rules-based exposure to the E-Mini S&P 500 futures. While this may sound insightful, most investors are left grappling with jargon that can obscure the underlying risks and mechanics of the investment.

The unsettling truth is that although advisors may present these products with confidence, their complexity often leaves investors confused and dependent on the advisor’s guidance. This dependence benefits the advisors, who may themselves be struggling to fully understand the intricacies involved. In the case of structured notes, advisors are aware of a few important realities: they receive a substantial upfront fee for each investment, and if the note is paid off early, which is something that happens fairly often, they have another chance to promote a new product and collect additional fees in the process.

Investors should tread carefully in this landscape. The lure of a 13% return can be inviting, yet it also comes tethered to the reality of high upfront costs and potential tax implications on that interest, which is taxed at the ordinary income rate. In a scenario where the underlying index drops more than 40%, the risks are palpable. Not only is the upside limited to that predetermined 13%, but the possibility of significant loss looms should the market not perform as hoped.

Furthermore, when times are good, and the index meets the right conditions, the issuer may call the note early. This leads to a particularly frustrating dynamic: while the investor anticipated earning interest, they find themselves cut off from potential gains as the notes are called. It raises an essential question: does the promise of complex instruments warrant the risks and fees involved?

In lifting the curtain on structured notes, we find that they may provide an option for growth, but at significant costs and risks that are often obscured by the initial allure. Investors who approach these products must do so with a clear understanding and a critical eye, recognizing that the sense of sophistication they bring may come at a higher price than anticipated. Ultimately, while structured notes may appeal to a desire for exclusivity and complexity, investors would do well to fully comprehend what they entail before diving into this intricate financial terrain.

Ryan Farias, CFA, Senior Portfolio Manager

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