When I first wrote about Understanding Structured Derivative Products As An Investment in 2012, I received some pushback. The media was going on about how structured products helped accelerate the financial crisis partly because investors didn’t understand what they were getting themselves into, much like how some adjustable rate mortgage borrowers didn’t understand how their loans worked. Further, readers said I could just create these structured investments myself with options for less money.
But I’m always one to keep an open mind about the various types of investments out there. And structured products so happened to fit my desire for some downside protection and upside participation. A structured product, also known as a market-linked investment, is a pre-packaged investment strategy based on a single security, a basket of securities, options, indices, commodities, debt issuance or foreign currencies.
In 2012, I had just negotiated a severance package after 11 years at my former employer. I was thrilled to get out of jail with money in my pocket, but I was also nervous that I no longer had a steady paycheck at age 34.
Despite the nerves, I mustered up the courage to invest in the S&P 500 and the Dow Jones Industrial Average with all my severance. I felt like I was playing with the house’s money because I almost didn’t get a severance after I had inadvertently sent an old client document to my personal e-mail as I was backing up more than a decade’s worth of material. My firm put my severance on hold for a week, then said everything was OK as the client document was old and immaterial.
Given I didn’t have a job, I didn’t feel 100% comfortable going naked long just in case the market recovery was a head fake. Therefore, I decided to invest in structured investments.
Without structured investments, I wouldn’t have felt confident investing at least $150,000 in 2012 and lots more in the stock market since 2013. Instead, I probably would have missed out on some of the equity rally by hoarding cash or buying CDs for security.
It’s easy to forget about the uncertainty back then since things have been so good for so long. Let’s see how these sometimes frowned upon and often misunderstood investments performed.
Structured Notes Performance Overview
I asked my banker to send me a spreadsheet of all my structured notes since I first started in 2012. For the sake of clarity, I’ve just highlighted the notes that have matured or are maturing in 2018. It’s a good way for me to recognize my cash flow, plan for tax liability, and think about how to reinvest the proceeds.
Thanks to a bull market, all the notes have provided a positive return net of fees. But because of the hedging element, some have underperformed their underlying indices, while others have outperformed.
Structured Note #1 – Underperformance
The first structured note was tied to the DJIA with a 0.5% annual interest payment. The return was based on the arithmetic average of the twenty-four interim index return percentages.
I liked the note because it provided 100% downside protection on its expiration date. In other words, if the DJIA was down 40% on 6/7/2018 from 5/30/12, I would have received 100% of my principal back. The only way I could lose is if Citibank goes bankrupt, so I went all-in.
If I had invested naked long in the DJIA index, I would have returned about 92% versus only 51.33%. But overall, I’m happy to have returned 51.33%, or 7.2% a year on average because my target return based on my risk tolerance and financial situation has been 4% – 5% since leaving work.
Not having to worry as much about losing money felt great. Further, not having $150,000 to draw from gave me motivation to make money. Money makes me lazy. And all I wanted to do after working for 11 years at one firm was sit on the beach.
Structured Note #2 – In-line Performance
The second note in 2013 was tied to the S&P 500 index. It offered a 30% barrier where so long as the S&P 500 was down less than 30% upon maturity, I would receive a 20% return upon maturity. In other words, if the S&P 500 was down 28% on 7/30/18, I would still earn 20%. Once the S&P 500 is up over 20%, I earn a 1-for-1 return. If the S&P 500 broke the 30% barrier, I would lose on a 1-for-1 basis as well.
My total return of 60.18% since 7/30/2013 at the time of this post mirrors the index’s performance. Too bad I only invested $10,000 in the index, but it was my way of increasing exposure to the S&P 500 with some protection. What I had to give up was earning an annual dividend yield of roughly 1.5% – 1.8%.
When the second note was purchased on 7/30/2013, I still wasn’t 100% sure whether leaving my job was a good idea. I gave myself a two-year time limit and I only had one year left to prove that I could be comfortable surviving on my own without a steady paycheck.
Structured Note #3 & #4 – Big Outperformers
The third structured note was purchased on 8/13/2014 based on the Euro Stoxx 50 index. The EU region lagged the US back then and I made a bet that they would catch up, and hence outperform.
This note is somewhat trickier, but hopefully, this chart will explain it clearly.
This chart shows that upon maturity of the note, if the Euro Stoxx 50 index is flat to down 29.9%, I get 100% of my principal back. If the Euro Stoxx 50 index is up 0.1% to +38% upon maturity, I get a guaranteed 38% return (nice!). Once the index goes above 38%, I get a 1-for-1 return. Only after the index declines by 30% or more do I get 1-for-1 downside.
To get this hedge, I gave up earning annual dividends for four years. I liked this investment because of the downside protection, but mostly because of the guaranteed 38% return if the index was barely up.
My hypothesis for EU stocks outperforming US stocks ended up being wrong. If you take a look at the chart below, you can see that since 8/14/2014, the Euro Stoxx 50 is only up 20% (vs +36% for the S&P 500 during the same time period.
But if you refer to my spreadsheet above, my third structured note is up 37.65%, for a healthy 17.65% outperformance of the Euro Stoxx 50 index so far. The note is essentially pricing in a 38% return upon maturity 8/13/18 because its unlikely the Euro Stoxx 50 will give up all of its gains by then. Remember, even if I’m up only 0.1% for the duration of this note, I get a guaranteed 38% return if Citibank is still standing.
My fourth structured note has the same conditions as my third structured note. It’s up only 34.66% because there’s still a greater chance the Euro Stoxx 50 could give up all its gains with a month longer expiration date.
Takeaways From Investing In Structured Products
Hopefully these four examples give you an idea of how structured products work. I know some of you will still hate them because it’s natural to hate what you do not understand. And of course, compared to an index ETF, the fees are much higher. Therefore, before you buy any structured product, consider the following:
* Understand your risk tolerance and how much you are comfortable losing
* Make an educated guess on where we are in the cycle and where will we be upon the note’s maturity
* Decide whether you need investment returns to live your life or to just run up the score
* Understand what you are giving up for downside protection and know the cost of each note
* Run through all the different return scenarios provided in the prospectus and calculate the returns net of fees
* Do you believe in the long-term viability of the institution that is issuing the notes
* Estimate your liquidity needs because these investments are not very liquid
* Calculate your opportunity cost given the risk-free rate is rising
Overall, the structured notes I invested in are doing their job of providing me exposure to the equities market while also providing downside protection. Remember, I’m not a big fan of equities, but know that I should have exposure over the long run.
While I was busy building Financial Samurai and optimizing my rental property portfolio, my structured investments provided a 7.2% – 10% annual tailwind, which is better than expected. I love when money quietly makes a return in the background without much worrying.
Delaying gratification is also an important takeaway from this post. I could have easily taken the $150,000 I got as part of my severance and blown $20,000 on an international vacation and $130,000 on a Porsche 911 TurboS. After all, it was basically free money so why not YOLO as a young man?
But I knew I had a self-imposed two-year deadline to build Financial Samurai financially strong enough so I wouldn’t have to go back to full-time work. Further, I was thinking about starting a family and wanted my wife to be able to stay at home with me as well. Responsibility.
I’ll continue to build a structured investment ladder with principal protection, especially at this late in the cycle. But I’ll also be more patient to wait for those notes that offer the best risk/reward scenario. The structured investments worked well in a bull market, so I’m hoping they’ll do even better in a bear market.
Readers, anybody else hedge their investments through structured notes? What type of investments allows you to sleep well at night the most? Do you think we tend to hate and fear what we do not understand?