Beware of Banks Bearing Promises

Icarus Tumbled Care for a 13% yield? This January, Barclays Bank issued a two-year structured note that pledged to pay $130 annually on each $1,000 of principal value. Try getting that deal from the United States Treasury. Then again, the U.S. Treasury tends to fulfill its promises, while Barclays' note did not make its very first scheduled quarterly payment. It will not again next quarter, barring a minor miracle.

If 13% strikes you as insufficient, consider upgrading to an 18% payout. An investor named William Mark enjoyed such receipts for five years, from a leveraged exchanged-traded note, or ETN, issued by UBS Group. He enthusiastically plowed those profits back into that security … until it went belly-up. Lamented Mark, "I'm 67 years old, and I'm basically bankrupt in just two weeks."

Through a coincidence, Morningstar and The Wall Street Journal broke these stories one day apart. On Monday, The Journal relayed Mark's account. The following day, Morningstar's Amy Arnott and Maciej Kowara released research on structured products. The Journal's article focused on personal tales, while Morningstar's featured investment details, but they carried the same moral: Beware of banks bearing promises.

First Cousins Structured notes and ETNs are broadly alike, although not identical. Both are derivative assets that are underwritten by banks. Effectively, they are puppet investments, as their strings are pulled by other securities (which is why they are called "derivative"). For example, whether the Barclays note pays its dividend depends upon the level of Diamondback Energy's FANG stock price.

Where the two investments diverge: Structured notes are issued with a termination date (typically a few years), are unlisted, and do not possess an official expense ratio. Instead, they profit on the unstated spread between what they cost to create, and what investors pay to purchase. In contrast, ETNs exist indefinitely, trade on an exchange (duh), and levy a standard expense ratio.

Overall, the similarities between the two outweigh their differences.

First, neither structured notes nor ETNs operate by pooling investments, as do mutual funds and exchange-traded funds. The latter use their shareholders' assets to buy securities that are custodied elsewhere. Not so structured notes and ETNs. Their returns come directly from their underwriters' pockets, as with a certificate of deposit. Legally, they also resemble CDs rather than funds, in that neither structured notes nor ETNs are registered under the Investment Company Act of 1940. They have no boards of directors and their owners are just that--owners, not shareholders.

Second, although structured products and ETNs need not be esoteric, they tend to be that way because of marketing demands. It's difficult to attract buyers to a new and different way of owning conventional assets, because the major mutual fund (and ETF) sponsors have already claimed that ground. Banks have therefore been pushed to offer investments that their rivals do not.

For Example Consider this "contingent income callable [structured] note" issued by Goldman Sachs, with a 2.5-year maturity date. Each quarter, the note pays a dividend of 2.275%, under the condition that the daily prices of the S&P 500, Russell 2000, and Euro Stoxx 50 indexes never drop below 75% of their initial values, as recorded on the day that the note was issued. Should any of those three indexes not reach the 75% mark, even for a single day, the quarterly dividend is canceled.

Stock market losses also affect the note's final payoff. Should all three indexes be worth at least 70% of their beginning value on the maturity date, its holders will receive their initial investment. However, if an index has dropped by more than 30%, then that index's loss will determine the size of the amount paid at maturity. Assume that the Euro Stoxx 50 Index finishes at 68% of its starting level, while the two U.S. indexes perform well. At redemption, the note would repay 68% of its par value.

Finally, Goldman Sachs retains the right to call the note, for any reason. Presumably, the reason would be if stocks rose sharply after the note's issuance, in which case calling the note would relieve Goldman of its obligation to pay future coupons. Sadly, that action would also relieve investors of their potential gains. But perhaps that scenario is unrealistic, because Goldman would preserve investor returns at the expense of its own profits. (Care to meet my new pet?)

This security is no beauty. Kowara generated 10,000 potential results for the note, through simulations that used historical daily performances of the three indexes. The average expected cumulative return for his exercise was a piddling 4.2%, with a "non-negligible probability" that the note would suffer a loss greater than 25%. Generously for Goldman, Kowara's analysis excluded the effect of the note's call provision, owing to the difficulty of modeling Goldman's potential decisions.

Storytellers Interested in buying a complicated version of a CD that is expected to return 1.67% per year, might lose a bundle, and could be called at the issuer's discretion? One suspects not. Of course, that wasn't how the note was sold. It was moved by pointing to its 9.1% annual yield, while waving off the possibility that one of the underlying stock indexes would plummet. Such events, after all, rarely occur.

True, it is unlikely that a stock index will be down more than 25% from its current value, when calculated on a single future date. However, when the indexes are increased from one to three, and that single future date becomes any date over the next 30 months (as when computing the coupon payment), then the possibility of loss becomes meaningful. The bank that created the note understands the odds; the buyer almost certainly does not.

The U.S. mutual fund industry, followed later by ETFs, has accumulated almost $20 trillion in assets by keeping things simple. Purchase almost any major fund, whether passively or actively managed, and rest assured that it will perform much like a conventional investment index. What you see is what you will get. The same does not necessarily hold for structured notes and ETNs that are offered by banks.

For that reason, although those securities are acceptable in principle, they should be approached warily, if at all. Too often have they abused investors' faith.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.