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.
Fact Check: The Truth Behind Five ESG Myths
ESG investing continues to break fund inflow records. In this infographic, we unpack five common ESG myths.
Fact Check: The Truth Behind 5 ESG Myths
In 2021, investors continue to embrace environmental, social, and governance (ESG) investments at record levels.
In the first quarter of 2021, global ESG fund inflows outpaced the last four consecutive quarters, reaching $2 trillion. But while ESG gains rapid momentum, the CFA Institute shows that 33% of professional investors surveyed feel they have insufficient knowledge for considering ESG issues.
To help investors understand this growing trend, this infographic from MSCI helps provide a fact check on five common ESG myths.
1. “ESG Comes at the Expense of Investment Performance”
Fact Check: Not necessarily
Worldwide, ESG-focused companies have not only seen higher returns, but stronger earnings growth and dividends.
|Returns by ESG Ratings||Earnings Growth*||Active Return**||Dividends and Buybacks|
Source: MSCI ESG Research LLC (Dec, 2020)
*Contribution of earnings growth and dividends/buybacks to active return
**Active return is the additional gain or loss compared to it respective benchmark
In fact, a separate study from the CFA Institute shows that 35% of investment professionals invest in ESG to improve their financial returns.
2. “Investors Talk About ESG But Don’t Invest In It”
Fact Check: False
Global ESG assets under management (AUM) in ETFs have grown from $6 billion in 2015 to $150 billion in 2020. In just five years, ESG AUM have accelerated 25 times.
Today, money managers are focusing on the following top five issues:
|Top ESG Issues||Assets Affected||Growth in Assets Affected (2018-2020)|
|Climate change / carbon emissions||$4.18T||39%|
|Sustainable natural resources / agriculture||$2.38T||81%|
Source: US SIF Foundation (Nov, 2020)
Meanwhile, over 1,500 shareholder resolutions focused on ESG-related matters were filed between 2018-2020. Not only are investors turning to ESG assets, but they are placing higher demands on corporate responsibility.
3. “ESG Investment Strategies Eliminate Entire Sectors”
Fact Check: Not necessarily
First, not all ESG investment approaches are exclusionary.
For instance, in North America roughly 51% of ESG ETFs used an ESG integration approach as of Dec. 31, 2020. In an ESG integration approach, ESG risks and opportunities are analyzed with the goal to support long-term returns.
By comparison, values and screens approaches, which accounted for over 22% of ESG ETFs in North America may screen out specific business activities, such as alcohol or tobacco, or sectors such as oil & gas.
|Percentage of ESG Type||Integration||Values & Screens||Thematic||Impact|
Source: Refinitiv/Lipper and MSCI ESG Research LLC as of Dec 31, 2020 (MSCI Feb, 2021)
Second, companies are assessed on a sector-specific basis where ESG leaders and laggards are identified within each sector in comparison to peers. In other words, ESG doesn’t mean eliminating exposure to entire sectors. Instead, investors can choose from a range of companies based on their ESG ratings quality.
4. “ESG Investing Is Only For Millennials”
Fact Check: False
Although ESG is popular among millennials, ESG investing is being driven by the entire investor population. In 2019, one study finds that 85% of the general population expressed interest in ESG investing.
|Interest in Sustainable Investing||General Population||Millennials|
Source: US SIF Foundation (Nov, 2020)
Sustainable investing goes far beyond millennials—ESG disclosures are quickly becoming requirements for key industry participants, such as institutional investors and listed companies.
5. “ESG Investing is Here to Stay”
Fact Check: True
Climbing 28% in 2020 alone, over 3,000 signatories have committed to the UN Principles of Responsible Investment. As of the first quarter of 2021, 313 global organizations and 33 asset owners have been newly added.
|Growth of UN PRI||Number of Signatories*||AUM Represented|
Source: UN PRI
*As of Mar, 2020
Central to ESG’s growth is the availability of ESG investments. ESG investing has become more widely accessible—which wasn’t always the case. Over the last decade, the global number of ESG ETFs has grown from 46 to 497.
Why the Facts Matter
As ESG investments continue to play an even greater role in investor portfolios, it’s important to focus on data rather than prevailing ESG myths that are not backed by fact.
Given the recent momentum in investment returns and ESG adoption, data-driven evidence empowers investors to build more sustainable portfolios that better align with their investment objectives.
ESG Investing: Finding Your Motivation
New research around ESG investing highlights that there are three common motivators for investors to invest in ESG assets.
ESG Investing: Finding Your Motivation
Environmental, social, and governance (ESG) factors are a set of criteria that can be used to rate companies alongside traditional financial metrics.
Awareness around this practice has risen substantially in recent years, but how can investors determine if it’s a good fit for their portfolio?
To answer this question, MSCI has identified three common motivations for using ESG in one’s portfolio, which have been outlined in the graphic above.
The Three Motivators
According to this research, the three primary motivations for ESG investing are defined as ESG integration, incorporating personal values, and making a positive impact.
These goals are not mutually exclusive, though, and an investor may relate to more than just one.
#1: ESG Integration
This motivation refers to investors who believe that using ESG can improve their portfolio’s long-term results. One way this can be achieved is by investing in companies that have the strongest environmental, social, and governance practices within their industry.
These companies are referred to as “ESG leaders”, while companies at the opposite end of the scale are known as “ESG laggards”. From a social perspective, an ESG leader could be a firm that promotes diversity and inclusion, while an ESG laggard could be a company with a history of labor strikes.
To show how ESG integration may lead to better long-term results, we’ve compared the performance of the MSCI ACWI ESG Leaders Index with its standard counterpart, the MSCI ACWI Index, which represents the full opportunity set of large- and mid-cap stocks across developed and emerging markets.
The MSCI ACWI ESG Leaders Index targets companies that have the highest ESG rated performance in each sector of its standard counterpart. The result is an index with a smaller number of underlying companies (1,170 versus 2,982), and a relative outperformance of 7.9% over 156 months.
#2: Incorporating Personal Values
ESG investing is also a powerful tool for investors who wish to align their financial decisions with their personal values. This can be achieved through the use of negative screens, which identify and exclude companies that have exposure to specific ESG issues.
To see how this works, we’ve illustrated the differences between the MSCI World ESG Screened Index and its standard counterpart, the MSCI World Index.
The MSCI World ESG Screened Index excludes companies that are associated with controversial weapons, tobacco, fossil fuels, and those that are not in compliance with the UN Global Compact. The UN Global Compact is a corporate sustainability initiative that focuses on issues such as human rights and corruption.
#3: Making a Positive Impact
The third motivation for using ESG is the desire to make a positive impact through one’s investments. Also known as impact investing, this practice enables investors to merge financial gains with environmental or social progress.
Investors have a variety of tools to help them in this regard, such as the MSCI Women’s Leadership Index, which tracks companies that exhibit a commitment towards gender diversity. Green bonds, bonds that are issued to raise money for environmental projects, are another option for investors looking to drive positive change.
ESG Investing For All
With various angles to approach it from, ESG investing is likely to appeal to a majority of investors. In fact, a 2019 survey found that 84% of U.S. investors want the ability to tailor their investments to their values. Likewise, 86% of them believe that companies with strong ESG practices may be more profitable.
Results like these underscore the high demand that U.S. investors have for ESG investing—between 2018 and 2020, ESG-related assets grew 42% to reach $17 trillion, and now represent 33% of total U.S. assets under management.
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