I came across an interesting quote yesterday that says we should gear our thought process and decision making “in terms of probability rather than possibility.” This afternoon, I decided to spend some time browsing through SEC – EDGAR database’s for “SEC Form 424B2”, a form financial institutions have to submit before they offer their financial products to the market. However, what’s is more interesting is the growing popularity of these so called “structured investments”. The complexity and implications behind these products could perhaps eclipse that of collateralized debt obligations (CDO) from the GFC given the substantially longer holding risk in a relatively higher liquidity and volatility nature of the product. Some of these products are hedged on the major indices (SP/DOW/Nikkei/FTSE) but even more are hedged on exchange-traded products (ETP). I went through and reviewed about a few hundred of these products out of 50,000+ in the past 3 years alone and have noticed some common trends:
- Limited Upside but Max Downside – Most of the product offerings out there are notes with that will return an x % in the next year or two, sometimes with the use of 1.5-3.0x leverage. However, most cap the return ~10%. Meaning even if the the underlying indices and/or ETPs delivers 80% growth in the next two years, the amount the investor will get in return at maturity is still 10%.
- However, investors bear close to 100% of the downside in that these actually very illiquid products aka not tradeable on any open market and price in determine by the issuers. Here is an actual note from the footnote of the prospectus, hence if the issuers decides this new investment product they offer is worth $0.01, then they are legally obliged to do so per the note, regardless of whether the under performing asset just experienced a -5% or -99% decline in value. Risk management (downside risk management) also becomes substantially more challenging as these notes are usually hedged onto an ETF/ETP which is then hedged to the underlying securities and further more, these are not tradeable on the open market so price discovery mechanism might not even be there. Who knows reading the footnotes is so fun.
“The notes will not be listed on any securities exchange. Accordingly, the price at which you may be able to trade your notes is likely to depend on the price, if any, at which the issuer is willing to buy the notes. You may not be able to sell your notes.”
- New Structured Investment Product Offerings High Correlation with Market Demand – These products are highly correlated with what the market “think” is hot right now – for example, there have been a lot of new structured investment products created in the past few months which are linked to European and Asian equities given their “relatively” affordable price to that of US equities (best of the two but doesn’t necessarily mean economic fundamentals are there).
- Increasing Use of Leverage – I traced a few of these structured investments with similar terms back to 2013 and have noticed an increasing use of leverage, most in the 1.5-3.0x, in the past two quarters. Furthermore the increasing complexity of these structured products are worrisome. Here is the title of one of the latest structured note offerings underwritten on yesterday, 10/3/2017.
Dual Directional Contingent Buffered Return Enhanced Notes Linked to the Lesser Performing of the Russell 2000® Index and the S&P 500® Index”
- Notes Offerings but with Complexity – Issuers sell these so-called “notes” as actual notes where the return is fixed and is highly tied to underlying balance sheet of the company themselves. For example, you might buy McDonald’s bond because you know the risk is low per their well-managed balance sheet and substantial free cash flow every year. However, these notes does not have a direct linkage to the underlying assets because most of these are tied to an ETF which are tied to the overall index which consist of the individual companies themselves.
- Limited Liquidation Preference – One of beauty of investing in distressed debt in the ability to have the up-most liquidation preference in times of bankruptcy. These “so-called” structured investment notes does not have any liquidation preference therefore downside risk management is therefore extremely limited.
- Short Duration Term and Untraceable – These so-called structured investment products are relatively new to the market + it is very challenging to trace these in public databases (not broken out in earnings release and I currently couldn’t located much info if any in SEC or security sources. Most of them are have a duration of 1-2 years and a few in the 5 year range.
I am not indicating whether structured investment product is a good or bad investment but just that whoever buys into them have to do it with extreme caution by reading throughout the whole prospectus including the footnotes and putting some thoughts in the points above, especially point #1 of limited upside and max downside and point #6 of short duration and the untraceability nature of the new financial products. Best of luck trading.
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