Structured Notes: The Secret to Improving Your Risk/Return Profile?
Structured notes are gaining momentum in the market, with a whopping $2 trillion in assets under management (AUM) globally.
So why haven’t more investors heard of them?
Traditionally, structured notes had a $1 million minimum investment. They were only available to high-net-worth or institutional investors—but they are now becoming more accessible.
Today’s infographic from Halo Investing explains what structured notes are, outlines the two main types, and demonstrates how to implement them in a portfolio.
What is a Structured Note?
A structured note is a hybrid security, where approximately 80% is a bond component and 20% is an embedded derivative.
Structured notes are issued by major financial institutions. Since they are the liability of the issuer, it is critical that the investor is comfortable with the issuer—as with any bond purchase.
Almost all structured notes have four simple parameters.
- Maturity – The term typically falls within 3 to 5 years.
- Payoff – The amount the investor receives at maturity.
- Underlying asset – The note’s performance is linked to the price return (excluding dividends) of an asset, such as stocks, ETFs, or foreign currencies.
- Protection – The level of protection the investor receives if the underlying asset loses value.
As long as the underlying asset does not fall lower than the protection amount at maturity, the investor will receive their initial investment back in full.
This is the primary draw of structured notes: they provide a level of downside protection, while still allowing investors to participate in market upswings.
Types of Structured Notes
There are a variety of structured notes, providing investors with diverse options and a range of risk/return profiles. Structured notes generally fall into one of two broad categories: growth notes and income notes.
Investors receive a percentage—referred to as the participation rate—of the underlying asset’s price appreciation.
For example, a growth note has the following terms:
- Maturity: 5 years
- Participation rate: 117%
- Underlying asset: S&P 500 index
- Principal protection: 30%
Here’s what the payoff would look like in 4 different scenarios:
|S&P 500 return||Growth Note Return|
The S&P 500 can return a loss of up to 30%, the principal protection level in this example, before the note starts to lose value.
Over an income note’s life, investors receive a fixed payment known as a coupon. Income notes do not participate in the upside returns the way a growth note does—but they may generate a higher income stream than a standard debt security or dividend-paying stock.
This is because protection is offered for both the principal and the coupon payments. For example, say a note’s underlying asset is the S&P 500, and it pays an 8% coupon with 30% principal protection. If the S&P 500 trades sideways all year—sometimes slightly negative or positive—the note will still pay its 8% coupon due to the protection.
Income notes have another big advantage: their yields can spike in tumultuous markets, as was demonstrated during the market volatility near the end of 2018.
Why did this spike occur? Banks construct the derivative piece of an income note by selling options*, which are more expensive in volatile markets. Banks then collect these higher premiums, creating larger coupons inside the structured note.
Investors can diversify their return profile by using a combination of growth and income notes.
*Option contracts offer the buyer the opportunity to either buy or sell the underlying asset at a stated price within a specific timeframe. Unlike futures, the buyer is not forced to exercise the contract if they choose not to.
Structured notes are powerful tools that can accomplish almost any investment goal, and investors commonly use them as a core portfolio component.
- Step 1: Select a portfolio asset class where downside protection is desired.
- Step 2: Reallocate a portion of the asset class to a structured note
- Step 3: Improve risk/reward performance.
The asset class will demonstrate an enhanced return profile, with less downside risk.
A Global Market
While relatively small in the Americas, the structured notes market is growing on a global scale:
|Region||AUM (2019 Q2)|
In the first half of 2019, assets under management in the Americas was up by 4%. It’s clear the asset class presents enormous untapped potential—and investors are taking notice.
Lowering Barriers Through Technology
Technology is becoming more ingrained in wealth management—empowering investors to access structured notes more easily through efficient trading.
The market is already becoming more accessible. By 31 October 2019, the average transaction size had decreased by almost $500,000 over the year prior.
Technology also offers other benefits for investors:
- Improved analytics
- Investment education
- Risk information
- Increased competition = lower fees
- Improved secondary liquidity
As more investors take advantage of this asset class, they may be able to improve their return potential while limiting their risk.
How to Avoid Common Mistakes With Mining Stocks (Part 3: Jurisdiction)
“Location, location, location…”
This famous real estate adage also matters in mining. After all, it’s an industry that is all about the geology—but beyond the physical aspects and the location of a mineral deposit, there are also social and environmental factors that create a mining jurisdiction.
Common Mistakes With Jurisdiction
We’ve partnered with Eclipse Gold Mining on an infographic series to show you how to avoid common mistakes when evaluating and investing in mining exploration stocks.
Part 3 of the series focuses on six signals investors can use to gauge a company’s preparedness for the jurisdictions they operate in.
#1: Geological Potential: Methodical Prospecting or Wild Goose Chase?
It all starts with a great drill result, but even these can be “one-off” anomalies.
Mineral exploration is a methodical process of drawing a subsurface picture with the tip of a drill bit. A mineral discovery is the cumulative effort of years of research and drilling.
The key to reducing this geological risk is to find a setting that has shown previous potential and committing to it. Typically, a region is known to have hosted other great discoveries or shares a geology similar to other mining districts.
Signs of Methodical Prospecting:
- Lots of geological indicators
- Potential for further discovery
- Sound science
#2: Legal Environment: Well-Paved Path or Minotaur’s Maze?
Now that you have identified a region with the prospective geology you think could host a discovery, a company will have to secure the permits to explore and operate any further.
However, a management team that cannot navigate a country’s bureaucracy will face delays and obstacles, costing investors both time and money.
Without clear laws and competent management, a mining company’s best laid plans become lost in a maze with legal monsters around every legal corner.
Signs of a Well-Paved Highway:
- Existing laws encourage mining investment
- Relatively low bureaucracy
- Well-established permitting process
- Legacy of mining contributing to economy
#3: Politics: Professional Politics or Banana Republics?
A good legal framework is often the outcome of politics and stable governance—however so is a difficult legal framework.
The political stability of a nation can turn on one election and so can the prospects for developing a mine. An anti-mining leader can halt a mining project, or a pro-mining leader can usher forward one.
A positive national viewpoint on mining may be enough to lure investment dollars, but local politics may determine the success of a mining company.
Signs of Professional Politics:
- Positive history with mining companies
- Politically stable jurisdiction
- Rule of law respected
- Changes in government have little effect on the mining industry
#4: Infrastructure & Labor: Modern or Medieval
Sometimes it is the discovery of valuable minerals that spurs national development, but this can also happen the other way around, in which development can encourage mineral discovery.
A mining company looking to build a new mine in a country with a tradition of mining will have an easier time. Access or lack thereof to modern machinery and trained employees will determine how much money will be needed.
That said, if a company is looking to develop a mining project in a new mining region, they must be ready to help create the skills and infrastructure it needs to mine.
Signs of a Modern Jurisdiction:
- Developed roads to access and support operations
- Trained labor for staffing and development
- Well-established grid lines and back-up power systems
#5: Community: Fostering Friendship or Sowing Enemies
Mining operations have a significant impact on the local community. Good companies look to make mutually beneficial partnerships of equals with local communities.
Ignoring or failing to respect the local community will jeopardize a mining project at every stage of its mine life. A local community that does not want mining to occur will oppose even the best laid plans.
Signs of a Friendly Relations:
- Operations bring community together
- Local history shows support for mining
- Understanding of local concerns and regional variety
- Company contributes to economic growth and health of the community
#6: Environment: Clean Campsite or One Night Party
There is no way around it: mining impacts the environment and local ecosystems. But, mining operations are a blip on the radar when it comes to Earth’s timeline.
Mine sites can again become productive ecosystems, if a company has the capacity and plan to mitigate mining’s impacts at every stage of the life of a mine—even beyond the life of a mine.
Signs of a Clean Campsite:
- Development plan mitigates environmental damage
- Well-planned closure and remediation
- Understand how communities use their environment
Bringing it together: ESG Investing
These six points outlined above point towards a more complete picture of the impacts of a mining project. Currently, this falls under what is labeled as Environmental, Social and Governance “ESG” standards.
Mining companies are the forefront of a big push to adopt these types of considerations into their business, because they directly affect natural and human environments.
ESG is no longer green wash, especially for the mining industry. Companies that understand and apply these concepts in their business will have better outcomes in the jurisdictions they operate within, hopefully offering investors a more successful venture.
Geology does not change on the human time scale, but bad management can quickly lose a good project and investor’s money if they do not pay attention to the other attributes of a jurisdiction.
By the Numbers: Are Tech IPOs Worth the Hype?
Technology IPOs draw massive investor and media attention, sometimes raising billions of dollars. But do tech IPO returns match up with the hype?
Tech IPOs — Hype vs. Reality
Initial Public Offerings (IPOs) generate massive amounts of attention from investors and media alike, especially for new and fast-rising companies in the technology sector.
On the surface, the attention is warranted. Some of the most well-known tech companies have built their profile by going public, including Facebook by raising $16 billion in 2012.
But when you peel away the hype and examine investor returns from tech IPOs more closely, the reality can leave a lot to be desired.
The Hype in Numbers
When it comes to the IPOs of companies beginning to sell shares on public stock exchanges, tech offerings have become synonymous with billion-dollar launches.
Given the sheer magnitude of IPOs based in the technology sector, it’s easy to understand why. Globally, the technology sector has regularly generated the most IPOs and highest proceeds, as shown in a recent report by Ernst & Young.
In 2019 alone, the world’s public markets saw 263 IPOs in the tech sector with total proceeds of $62.8 billion. That’s far ahead of the second-place healthcare sector, which saw 174 IPOs generate proceeds of $22.5 billion.
The discrepancy is more apparent in the U.S., according to data from Renaissance Capital. In fact, over the last five years, the tech sector has accounted for 23% of total U.S. IPOs and 34% of proceeds generated by U.S. IPOs.
The prevalence of tech is even more apparent when examining history’s largest IPOs. Of the 25 largest IPOs in U.S. history, 60% come from the technology and communication services sectors.
That list includes last year’s well-publicized IPOs for Uber ($8.1 billion) and Lyft ($2.3 billion), as well as a direct public offering from Slack ($7.4 billion). Soon the list might include Airbnb, which plans to list within the communication services sector instead of tech.
The Reality in Returns
But the proof, as they say, is in the pudding.
Uber and Lyft were two of 2019’s largest U.S. IPOs, but they also saw some of the poorest returns. Uber fell 33.4% from its IPO price at year end, while Lyft was down 35.7%.
And they were far from isolated incidents. Tech IPOs averaged a return of -4.6% last year, far behind the top sectors of consumer staples (led by Beyond Meat) and healthcare.
|Sector||Avg. IPO Return (2019)|
While last year was the first time tech IPOs have averaged a negative return in four years, analysis of the last 10 years confirms that tech IPOs have underperformed over the last decade.
A decade-long analysis from investment firm Janus Henderson demonstrated that U.S. tech IPOs start underperforming compared to the broad tech sector about 5-6 months after launching.
This dip likely corresponds to the expiry of an IPO’s lock-up period—the time that a company’s pre-IPO investors are able to sell their stock. By cashing in on strong early performance, investors flood the market and bring share prices down.
Interestingly, most gains for these IPOs tend to happen within the first day of trading. The median first-day performance for tech IPOs was a 21% increase over the offer price. That’s why the median first-year return for a tech IPO, excluding the first day of trading, is -19% when compared with the broader tech sector.
How to Make Money from Tech IPOs
So does that mean that investors should avoid tech IPOs? Not necessarily.
Longer-term analysis from the University of Florida’s Warrington College of Business shows that U.S. tech IPOs offer better returns than other sectors as long as investors get in at the offer price.
U.S. Tech IPO Returns from Offer Price
|Sector||Avg. Three-Year Return||Market-adjusted Return|
Even when adjusting for the broader market performance, tech IPOs have been solid in comparison to the offer price.
The challenge is that if investors are buying stock after that first day market bump, they may have already missed out on meaningful gains:
U.S. Tech IPO Returns from First Closing Price
|Sector||Avg. Three-Year Return||Market-adjusted Return|
So should investors shy away from tech IPOs unless they’re able to get in early?
Generally speaking, the analysis holds that new tech companies perform relatively well, but not better than the broader market once they’ve started trading.
However, in a world of billion-dollar unicorns, there are always exceptions to the rule. The University of Florida study found that tech companies with a base of over $100 million in sales before going public saw a market-adjusted three-year return of 24.4% from the first closing price.
If you can sift through the hype and properly analyze the right tech IPO to support, the reality can be rewarding.
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