Downside protection may not currently be top-of-mind for many investors, with the S&P 500 up 85% since the lows on March 23, 20201 to new all-time highs. And while the economic backdrop looking forward ought to be supportive of equities, we nevertheless recognize that valuations remain stretched, and some investors may be interested in options to protect their assets should the equity markets decline.
Structured Note Basics
Over the years, we have found that risk-averse clients often prefer to reduce equity volatility by investing in defined outcome investments like structured notes. These investments are tied to a particular index, allowing investors to participate in some of the upside of equities while also limiting downside risk. The final return outcome is predicated on three parameters that are defined when constructing the product—time frame, upside participation, and downside protection.
For example, a common structured note based on the S&P 500 might be arranged with a term of two years. Over that time frame, the note would mimic the movements of the market index but protect the investor against a decline of up to 10% (a 10% “buffer” against losses). To pay for this protection, the note also has a cap on upside returns. Such a cap might be on the order of 18% for a two-year note.
Below are four different illustrative market scenarios, and how the structured note would perform in each:
- The S&P 500 ends the two-year period up 10% (a positive return <= to the 18% “cap”). In this case, the structured note investment will also be up 10% – equal to the index return.
- The S&P 500 ends the two-year period down 8% (a negative return >= to the -10% “buffer”). Because the investor is fully protected on the first 10% loss, their return would be 0% – vastly outperforming the index return.
- The S&P 500 ends the two-year period up 30% (a positive return >= to the 18% “cap”). Because the product is capped at an 18% max return, the investor returns only 18%, which is 12% below the index but still a healthy annualized return on an absolute basis.
- The S&P 500 ends the two-year period down 30% (a negative return <= the 10% “buffer”). In this scenario, the note would return -20% after the protection provided by the loss buffer—again, vastly outperforming the index.
Thus, these notes fare the best in falling markets and worst when the market roars ahead.
Three Ways to Purchase Structured Notes
Investors have several options for purchasing this type of investment, with varying pricing, return, and tax characteristics.
- Standardized notes: Certain banks offer standardized structured notes to registered investment advisors (“RIAs”) at the beginning of every month. Because these are very regimented and offered to many RIA firms across the country, the cap rate, or maximum return an investor can achieve, is generally lower than other two alternatives listed below.
- Custom notes: Given Fragasso’s size and relationships, we can partner with investment banks to create customized notes that are only available to our clients. This allows us to negotiate higher cap rates giving our clients potential to earn a higher rate of return than if investing in the standardized note discussed above.
- ETFs: Structured products are now available in an ETF format. This is a very tax-efficient way to gain exposure to a structured note. In the two options previously mentioned, once the stated time period has passed and the investment matures, the proceeds are returned to the investor and a taxable event occurs. However, the ETF structure allows the holder to simply roll the proceeds into a new investment, thus mostly eliminating a taxable event. This can continue year after year until the investor decides they’d like to sell out of the ETF. Over time, the tax benefits of investing this way are likely to lead to significant tax savings.
The best option for an individual investor depends on his or her tax situation, timing considerations, and risk tolerance.
Peace of Mind Has a Price
Importantly, these investments are not a fit for all investors. Equity markets tend to rally over time, usually on an unpredictable timeframe. For example, stocks have done wonderfully against the backdrop of a global pandemic. Because of this, investors in the types of structured products often leave money on the table in rising markets. That said, they can provide peace of mind, and the best time to buy insurance is well before storm clouds form on the horizon. If you’re able to sleep better at night knowing that you have some downside protection in the event of an equity market sell-off, these investments could be suitable for your portfolio.
As with any portfolio changes, it is best to discuss these options with your financial advisor to evaluate whether they may be suitable in navigating you towards your unique goals. Your advisor and the portfolio management professionals at Fragasso welcome the opportunity to have this conversation.
Source:
1. Bloomberg