Structured notes for expats – are they a good idea?

Structured notes are complicated, but widely sold, investments in the expat market and beyond, including by many banks that target locals around the world. 

This article will example these investments in more detail. If you have structured notes in your portfolio and want a review, my contact details are or you can use the chat function. 

For those that prefer video content, the video below briefly explains structured notes:

What are structured notes?

A structured note is a financial derivative that tracks certain assets. They claim to be able to protect investors from the downside of markets.

They typically track numerous asset classes for a period of time and have something called a protection barrier and coupon trigger or investment yield. 

For example, a structured note could track 4 indexes. In this case let’s give an example of the UK FTSE 100, the US S&P 500 Index, the Japanese Nikkei and the Shanghai Composite Exchange. 

The note may last for 5 years, from 2019, until 2024. The notes pay out 2% quarterly (this is the coupon trigger or the investment yield), so 8% per year. 

However, the investor only gets this quarterly payment, if the investments don’t fall below 20% of their original value. 

If any of the investments within the note fall below 20% during the 3 month period, the investor doesn’t get the payment, even if the other 3-4 assets have risen in value!

The note is also protected, up to a point. So, in this case, the client gets their money back, at the end of the 5 years, provided the markets don’t fall by more than 35%. 

In many cases, if even 1 of the 4 or 5 underlying investments falls below the 35% barrier at matruity, the investor can lose a lot of money.

The above is one example (in this case based on indexes) of how structured notes are used. Many other notes track individual stocks, commodities and other assets. 

They are all based on the same principles though. Downside protection and the chance to make yields.

What’s not to like? Provided markets don’t fall more than 35%, you don’t lose money AND you will get many 2% quarterly payments?

Well it isn’t that simple. This article will explain this in more detail.

Where are structured notes typically sold?

They are widely sold in the expat markets, within lump sum products, as the article below explains in more depth. They are also sold in other onshore markets, focused on the local populations. 

What are some of the negatives of structured notes?

The above example shows how complicated structured notes are. You should also be wary of complexity, as opposed to simplicity.

Many structured notes may have a 35% protection barrier, but remember that still has a significant currency risk, especially as it only requires 1 asset to fall significantly.

Take the last 5 years as an example. The FTSE stock market didn’t fall by 30% after Brexit in British Pound terms, but did in US Dollar terms.

In fact, many currencies have fallen by 20%-30% in USD terms in the last 5 years . So all of a sudden, that 35% protection barrier doesn’t seem safe.

All you need is a 15%-20% devaluation + a 15%-20% falls in the stock market to breach the barrier, or indeed a 35.1% currency depreciation and 0% stock market growth.

In addition to that, structured notes have the following negatives;

  1. They don’t pay dividends. This is huge. As per the chart below, dividends have historically accounted for a huge part of the S&P’s historical performance:
Dividends play a huge role in investment returns 

In the UK in recent times, dividend yields have played an even bigger role in the performance of the stock market, due to the FTSE 100 having a 4.5% dividend yield, and less impressive capital appreciation:

UK dividends have been especially high recently.

2. Liquidity. It isn’t easy to sell structured notes early, unlike liquid funds. So if you need desperately need some cash, it isn’t easy to sell out. In addition to that, you can’t rebalance a portfolio very easily. 

One of the positives about liquid investments, is that you can rebalance if one component is performing especially well. For example, if your US funds are doing better than your UK ones, you might want to sell some of them, and thereby taking advantage of lower valuations in UK markets.

With structured notes, this isn’t easy. In fact, it is often impossible. 

3. Hidden costs. A lot of structured notes have hidden costs, and indeed, hidden risks. 

4. They can completely fail. If the issuing bank fails, an investor could lose all of their money. A guarantee is only as good as the guarantor’s ability to keep to their promises. 

Let us not forget that Lehman Brothers produced a lot of guaranteed products and notes. 

So in the same way that a debt promise made by the US Government is worth more than the Zimbabwean Government, which is why US Treasury Bills pay so little interest compared to emerging market debt, this risk level varies.

A structured note issued by Goldman Sachs or HSBC, is worth more than one offered by a tiny boutique bank in a developing country, without proper regulation.

In comparison, an investment like an index fund can’t completely fail, unless there is a nuclear war and stock markets no longer exist……

5. The assets that are typically picked, within this note, can cause losses. To give the structured notes their price, 1 of the assets from the 4-5 assets, tends to be riskier. This significantly increases the chances of missing coupon triggers and maturity payments. 

Remember if your note is based on the aforementioned 4 assets, you could lose money even if 3 of the markets have increased in price by 50%, by one has fallen by 35.1%. 

6. Markets like the US S&P have historically given 10% returns. Granted, this is merely a long-term average. 

Between 1985 and 1999, and 2009-2017, markets have exceeded those averages. Likewise, from 2000 until 2009, markets didn’t meet these averages.

Nevertheless, you have to remember that getting 7%-8% sounds good, but in reality is below market returns.

If you miss some of the quarterly payments, you could end up with 5% or less, for taking hugerisk. 

So are structured notes always awful investments?

I am not suggesting that 100% of structured notes are awful. Some are riskier than others.

Some very sophisticated investors have used them well. If they are 5% of your total wealth, you probably aren’t going to have many products.

In general, however, there are more sensible ways to manage your risk than this. Being long-term (time in the market as opposed to timing the market) and having a greater government bond exposure, are all tried and tested ways to manage market risk.

So why are structured notes popular?

There are two reasons. The banks and some other financial institutions can make a lot of money from these notes. 

This is because the amount a bank saves on interest is worth more than the option is worth, often 2%-3% more, and they get to charge a commission for the product.

They are, therefore, aggressively sold by some institutions. Secondly, they have a captive audience with some investors.

Because losses are more painful than gains are pleasurable, many investors don’t want to invest in the stock markets at all.

This isn’t sensible, because long-term, stocks have always gone up in a big way. Many new and inexperienced investors, are sold the idea that they can have their cake and eat it.

Get 70%-80% of the potential market gain, whilst having downside protection. In reality, there is no such thing as a free lunch.

It is also true to suggest that some investors assume a very sophisticated investment, is better than a simple one. So structured notes are disturbing other “professional investor type assets” like hedge funds, for this very reason. 

Are there any positives about structured notes?

It is true that they are very flexible. You can pick numerous currencies, indexes and individual investments within the same note.

They can be tax-efficient in many countries, as the gains are considered long-term capital gains, although most equity investments into low-cost funds are also tax advantageous.

Finally, if the actual investment or index is going down, they can be a good deal. In other words, let’s say you have a structured note linked to 3-4 indexes, including the US S&P500. It pays out 8% per year. During the next 5 years, the S&P500 falls by 10%.

All of a sudden, you are making 8% per year, when the market is falling. However, remember that historically, you don’t need to worry about market falls.

As the graph below shows, indexes tend to rise over time, meaning your chances of losing money fall over time:

Your chance of losing money in markets decreases over time

So often you don’t need these protection barriers, taking huge risks in the process, to get such “protections”. 

What has been the recent performance?

In the last 10 years, markets have been fairly positive. So this has resulted in two things; most notes haven’t completely failed, but have produced much lower than market averages.

Let’s therefore, look at the how many structured notes might have performed from 2008 (the year of the crisis) and the aftermath. In 2018, many indexes were down by 36%-37%. 

Structured notes would have likely fallen by 25%-30%, which sounds good in comparison, even though no dividends was paid to ease the fall.

Then in 2009, markets increased by 26%, meaning that structured notes investors would have lost out on a lot of growth. A 8% coupon doesn’t sound so good when markets are increasing by 26% a year!

And in reality, for most years of this current bull market, structured notes investors would have missed out on a lot of growth.

They would have only outperformed during one year most likely – the year of 20008-2009.

Warren Buffett had a famous $1m bet with a hedge fund manager more than 10 years ago, for charity. The bet was simple; hedge funds wouldn’t be able to beat the S&P500 over 10 years, even if they could do it for 1-2 years.

Buffett knows the maths behind hedge fund fees (which are similar to structured notes fees in a different kind of way), would impact net returns. 

Here was the result over the 10 year period:

Hedge funds lost the famous bet with Buffett

So with the exception of 1-2 years, the hedge funds vastly underperformed. I highly suspect Buffett would also be willing to bet on structured notes failing to beat indexes over any 10 year period!

Will the current crisis test structured notes?

There is no doubt that the current stock market crisis will test structured notes.

The main reasons for that are the big market falls we have witnessed in March 2020, and the liquidity issues the volatility will bring.

It is too early to tell what the ramifications will be for many of these notes, but some could fail.

There is no doubt that the general market indexes will come back, but many of the structured notes focused on individual stocks could suffer a lot.

Conclusion: are structured notes a good investment?

Structured notes can be used intelligently by professional investors, although I have yet to meet even an investment professional, that knows these investments inside out.

That should be a worry, because simplicity is your friend in investing, and complexity is your enemy.

For the average person, they generally aren’t suitable. Therefore, if you have them in your portfolio, you should consider an alternative investment, once the investment has ended. 

Often people buy into structured notes, because the “guarantee” gives people a feeling of security. In reality, this guarantee has many terms and conditions attached. 

There are alternative strategies that can be used, to lower your risks, such as being ultra long-term in stock markets, and adding a bond index to your portfolio.

The bottom line is the risk:reward ratio is low. If these notes were lowering 15% for such higher risk, you could argue it is worth taking a punt with 10% of your portfolio.

In reality, most notes offer 1%-2% below average market historical averages, in return for a lot of hidden risks. The upside is capped, with downside only partially covered.

The current stock market volatility as a result of the global health crisis could further test structured notes.

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