Structured Products: Right Idea, Wrong Execution

Structured products, also called structured notes, are customized versions of existing investments. A recent example is this offering from Morgan Stanley MS. Sold in June 2022, the company’s “market-linked notes” will pay their investors a minimum of their $1,000 purchase price and a maximum of $1,650 when the notes mature seven years later. The amount of that distribution will be determined by the performance of the S&P 500.

The product is “structured” because it reshapes the original investment’s risk/return proposition. Should disaster strike, causing the S&P 500 to lose half its value, Morgan Stanley will reimburse its investors in full, thereby pleasing Will Rogers. (Said he, “It is not the return on my investment that I am concerned about, it is the return of my investment.) If, on the other hand, the index were to increase, the company would share its early profits. After a certain point, though, Morgan Stanley would reserve the remaining gains for itself.

A Sound Idea

The modification is logical. Many investors heartily dislike losing capital. Morgan Stanley’s note gives such customers the chance to capture higher gains than they could otherwise achieve through a guaranteed investment. In June 2022, seven-year Treasury notes yielded 3%, thereby making for a 23% cumulative return—barely one third of the structured note’s maximum payout. Almost everybody would like to participate, at least partially, in the stock market’s appreciation. But not all have the constitution to invest in equities, even as a part of a diversified portfolio.

That argument, perhaps, can be dismissed as capitulating to an unhealthy mindset. Those who cannot accept losing capital are not investors but instead savers in disguise. Besides, the math is faulty. If future inflation averages 4% per year, then investors who receive the note’s par value when the security matures will have lost almost one third of their purchasing power over the succeeding seven years. Does that really qualify as principal preservation?

The counterattack, I confess, has merit. Nonetheless, there is value in reshaping a security’s risk/return profile. If this note does not satisfy, then another product can be built to new specifications. Thus, rather than deliver those features, Morgan Stanley could instead have guaranteed something close to an inflation-adjusted return of principal, with a smaller payout if the S&P 500 does appreciate.

What’s more, as discussed by my colleague Madeline Hume in her recently published white paper, “A Simple Framework for Structured Products” (which she summarized in this article), structured products can do more than protect principal. They can also boost yield or combine the performances of multiple assets. Naturally, there are trade-offs. To achieve such enhancements, structured-product purveyors buy derivative securities. They then recoup the costs of those investments by removing some aspects of the product’s performance.

An Expensive Proposition

All fine; it would be naive to expect something for nothing. But now begin the problems. In addition to covering investment costs, issuers impose their own charges. Fair enough. Businesses that sell structured products exist to make money, the same as fund companies. However, their prices are very different!

Consider the cost of Morgan Stanley’s note. Its term sheet estimates the outlay for creating each security at $920.90. (Rather than receive ongoing management fees, as with mutual funds and exchange-traded funds, structured-product issuers are paid by the initial sale’s profit.) That makes for a 10.9% up-front commission, which equates to annual expense ratio of 1.55%. That is decidedly old-school pricing—and in the investment industry, as with technology, “old school” is no compliment.

Here is another example. Last year, JPMorgan Chase JPM sold a “capped buffer equity note” that will compensate its investors based on the worst-performing equity index, among the three selections of the Dow Jones Industrial Average, the Russell 2000, and the S&P 500. That product had an 18-month maturity date and a 2.91% implied commission, making for an annual expense of 1.94%.

Further Problems

Besides being costly, structured products possess three additional drawbacks. The first is counterparty risk. As with other forms of insurance, structured products rely upon their issuers’ credit. If a fund company declares bankruptcy, no worries. Invested and custodied elsewhere, fund assets are unaffected by organizational woes. However, companies that provide structured products pay those obligations directly, out of their own pockets. Should they become insolvent, their structured-product investors will find themselves standing in the creditors’ line.

Another impediment is the lack of a secondary market. In the words of the SEC, “A liquid market for structured notes does not exist. If you want to sell your structured note before it matures, you might have to do so at a price less than the amount you paid for it, or you may not be able to sell it at all.” Owners of equities, government bonds, and public funds can upon request liquidate their investments within one day for mutual funds, and much more rapidly than that for other investments. No so for those who buy structured products.

Finally, little third-party information is available on structured products. There could be such research, as the term sheets contain enough data to permit useful analysis. But the nature of the industry defeats the endeavor. Structured products are issued in dribs and drabs, with each offer customized for that week’s investment conditions. Consequently, although the marketplace is reasonably large, with 2022 bringing $94 billion in new U.S. structured-product issuance, it lacks scale. Structured products are too small to merit the research effort.

A Solution?

Ideally, structured products would be offered by closed-end funds, rather than as bank notes. Moving structured products into registered funds would address each of their current drawbacks. Launching a product as a fund should create greater investor volume, thereby cutting costs. In addition, counterparty risk would shrink (although still be present for securities that used customized derivatives); liquidity would improve; and outsiders would be likelier to supply third-party evaluations.

Whether such an arrangement is operationally feasible, or if it would succeed in the marketplace (closed-end funds are not currently fashionable), exceeds my knowledge. I can speak only to structured products’ investment attributes. They very much exist. Unfortunately, though, they are inadequately delivered.