I'm always looking for new investment ideas due to excess cash flow. All of you who spend less than you make should have the same problem. But given we are near all-time highs in the stock market, good ideas are harder to come by.
I'm also always being asked by folks who discover my background whether I have any investment ideas for them. I usually play dumb so I can live a more peaceful life. Besides, everybody's financial situation and risk tolerance is different.
For the sake of growing our knowledge, I'm going to do something different from now on. Every time I stumble across a good investment idea where I plan to invest a significant amount of capital ($10,000+), I'll write about it if allowed. I'll lay out my bullish argument and the FS community can proceed to tear it up. The community will get to learn how to analyze similar investment ideas in the future so we can all get smarter.
The Easiest Investment Ideas
Before we talk about my latest investment idea, let me remind everyone about a perennially good idea: paying down debt, no matter how low the interest rate. After all, a small positive return is better than a loss if the markets correct. Not once have I regretted paying down debt. Even if the money I put towards debt could have made more money in an investment, I'm happy reducing debt.
Another great idea is to invest in your business or yourself. There's a good chance with additional capital expenditure your business or career will grow faster than the market. For example, Financial Samurai was a triple digit grower for the first five years, easily crushing the returns of the market. Getting an MBA part-time to invest in my career also paid off due to a promotion the year I graduated. Do not underestimate the power of you.
If you've already developed a steady debt pay down strategy and you're already spending wisely on yourself or business, here's one of my investment ideas that might intrigue you. This article is relevant for those who:
- Are afraid of investing in the stock market at all-time highs
- Want to know how to invest in hedged investments
- Invest for the long term
- Feel they have too much cash
Overcoming The Fear Of Investing
Despite the fees (0.5% – 2%), I'm a fan of structured notes. Many of them provide a downside buffer or barrier in a particular investment plus full upside participation. Back in 2012, I didn't have the courage to invest $150,000 of my severance check into the stock market because I had no job. But I felt strongly then, as I do now, that it's important to continuously invest for the long run, no matter what your situation.
What gave me the courage to invest back then was a principal protected structured note. In other words, no matter what happens over the six-year note term, I can get 100% of my money back provided the issuing bank is still in business. If the market went up 100% during this time period, I'd also be up 100%.
What was the catch? The minimum investment amount was $50,000. And I would only receive a 0.5% annual dividend versus a 2% annual dividend if I had bought a DJIA index ETF naked (no protection) instead. The issuing bank would also get to use my money as they pleased.
It's been over four years since I bought the note, and it's annualized an ~8.8% return net of fees. I took $53,000 in profits off the table in August for some home improvement projects. There was no penalty for selling a portion of my note early either. Although they usually charge a 1% fee. My banker forgot to tell me before I sold, so he waived the charge. I'm letting the remaining $150,000 principal balance ride until the note expires.
Another approach to consider is dumbbell investing, a strategy that involves allocating a roughly equal portion of your investable assets into high-risk, high-reward investments on one end, and low-risk, capital-preserving investments on the other.
See: Practice Taking Profits To Pay For Life
Utilize Investment Ideas That Offer Downside Protection
There is no way I would have gone “all-in” if there wasn't any downside protection. I've since invested in many more structured notes since 2012 to overcome my fear of investing in the stock market. When you've invested through the Russian Ruble Crisis, the Asian Financial Crisis, the dotcom bomb, SARs, and the US housing implosion, you have a lot of battle scars.
When you retire early or set out to become an entrepreneur, the desire for cash is more intense.
For those of you who are also concerned about going naked long when the stock market is at its all-time high, take a look at the below investment.
Investment Ideas At The Top Of The Market
Here's an example of a structured note that can be a good investment idea in a bull market. First, study the chart and see if you can understand what this note is offering. We'll then discuss the terms in detail below.
Terms Of The Structured Note
Underlying Security: S&P 500 Index (as plain vanilla as it gets)
Barrier: 30% (won't lose money so long as the S&P 500 doesn't decline by more than 30% on the date the note expires)
Participation Upside: 150% uncapped (1.5X the return at maturity net of fees)
Dividend: None (miss out on the 2-2.5% S&P 500's annual dividend)
Maturity: Sept 2021 (5 years)
Fee: half a percent e.g. invest $1,000, $5 goes to the bank.
Example 1—Upside Scenario
The hypothetical final index level is 2,296.35 (an approximately 5.00% increase from the hypothetical initial index level), which is greater than the hypothetical initial index level.
Payment at maturity per security = $1,000 + the leveraged return amount = $1,000 + ($1,000 × the index percent increase × the leverage factor) = $1,000 + ($1,000 × 5.00% × 150.00%) = $1,000 + $75.00 = $1,075.00
Because the underlying index appreciated from the hypothetical initial index level to the hypothetical final index level, your payment at maturity in this scenario would be equal to the $1,000 stated principal amount per security plus the leveraged return amount, or $1,075.00 per security.
Example 2—Par Scenario
The hypothetical final index level is 2,077.65 (an approximately 5.00% decrease from the hypothetical initial index level), which is less than the hypothetical initial index level but greater than the hypothetical barrier level.
Payment at maturity per security = $1,000 Because the underlying index did not depreciate from the hypothetical initial index level to the hypothetical final index level by more than 30.00%, your payment at maturity in this scenario would be equal to the $1,000 stated principal amount per security.
Example 3—Downside Scenario
The hypothetical final index level is 656.10 (an approximately 70.00% decrease from the hypothetical initial index level), which is less than the hypothetical barrier level.
Payment at maturity per security = $1,000 × the index performance factor = $1,000 × 30.00% = $300.00.
Because the underlying index depreciated from the hypothetical initial index level to the hypothetical final index level by more than 30.00%, the contingent repayment of the stated principal amount at maturity would not apply.
Financial Analysis
When I first saw this note I wanted to immediately invest $200,000, or ~70% of my liquidity (but less than a 5% position in investable assets). To be able to get 150% of the upside sounds so good. Let's say the S&P 500 is up 40% in five years. Instead of being up $80,000, I'd be up $120,000. Meanwhile, with a 30% barrier, the chances of losing money drastically declines.
From the S&P 500's peak in 2007 to its low on Feb 1, 2009, it saw a decline of 51%. I doubt we'll see such a hammering if a bear market returns due to much more stringent lending standards over the past seven years. Banks and individuals are less levered, and more control mechanisms are in place.
Bear Scenario
If the bear scenario occurs, I assign a 20% probability the S&P 500 will decline by over 30% when the note comes due. The S&P 500 could decline by 90% during the five year time period but you'll still get your money back so long as the S&P 500 rallies upon expiration and is only down 30% or less. If the S&P 500 is positive upon expiration, then you get 1.5X the return.
Given this is a barrier note and not a buffer note, if the S&P 500 declines by more than 30% when the note expires, you'll lose exactly the amount the index declines. If this was a buffer note, then your downside would be helped by the buffer e.g. if the index is down 50%, your actual return will be down 20% because you'd have a 30% buffer.
Bull Scenario
In the bull scenario, it's important to compare new potential investment returns to the risk-free rate of return. Everybody can buy a 5-year CD yielding 2% today. After five years, your CD investment will have returned a guaranteed 10.4%, which I will assign as the bull scenario break even point. The more you believe the S&P 500 will be up 7% or greater after five years, the more it makes sense to invest in this note given the 1.5X kicker (7% X 150% = 10.5%).
If the S&P 500 goes up by 4% a year for five years, the S&P 500 will have returned 21.6% excluding dividends, and you will have returned 32.4% from this note. Even if the S&P 500 goes up by only 3% a year for five years, the S&P 500 will have returned 15.9% excluding dividends. Your total return would be 23.85% with this note.
Of course, bad things can happen within these five years as well. We could have a recession and the market actually goes down. There could be another international debt crisis that brings the world to its knees. Who knows for sure. There are always risks involved with investment ideas, even ones that seem foolproof.
The stock market feels like it's being artificially propped up by low interest rates. The Fed will most likely continue to raise the Fed Funds rate several times during this five-year period, creating headwinds for stock market performance.
I assign a 60% chance the S&P 500 will be 10.4% higher in five years.
Adding both scenarios leaves me with 20% to assign to a par scenario where the S&P 500 is up less than 10.4% or is down by no more than 30% in five years time.
You may want to invest in this note if:
- You are bullish on the stock market, but not bullish enough to go naked long.
- You're not in need of more investment income. The 1.5X kicker will help make up for lost dividends if the S&P 500 return is positive in five years.
- You are looking for a hedge because you feel there's a chance there will be a downturn over the next five years, but you still want equities exposure in your net worth.
- You're outlook is long-term and you don't mind locking up money for five years.
- * You have cash sitting in your IRA that can't be touched until 59.5.
Final Decision: I ended up investing a total of $200,000 in this structured note. $50,000 in my after-tax account and $150,000 in my rollover IRA.
So Many Ways To Invest
Fear of losing money is the biggest reason why people don't execute their investment ideas. Low cost wealth managers like Empower help reduce such fears. They can help you build, invest, and rebalance a risk-adjusted portfolio for you in public securities.
If you have more than $100,000 – $250,000 to invest, many big banks such as JP Morgan Chase and Citibank offer alternative investments to their private clients. These investment ideas help protect principal while also providing 100% or greater participation on the upside.
As someone who is neutral on the stock market after such a long bull run, investing in a note that provides a 30% barrier and a 1.5X upside kicker is really attractive. I have no delusions that my forecast for a soft market could be dead wrong. Let's hope we have an amazing 12-year bull market that makes us all mega rich! You just never really know, which is why we all must diversify.
Once you've amassed a comfortable financial nut to live off, you need to find ways to protect your nut in case of a downturn. Some great protection methods include earning passive income, consulting part-time, earning online income, and working the gig economy. Or, you can simply invest in a security that has a built-in hedge.
More Recommendations
Real Estate Crowdsourcing Investing Ideas
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Real estate is a key component of a diversified portfolio. Real estate crowdsourcing allows you to be more flexible in your real estate investments by investing beyond just where you live for the best returns possible. For example, cap rates are around 3% in San Francisco and New York City, but over 10% in the Midwest if you're looking for strictly investing income returns.
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Invest In Private Growth Companies
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The investment minimum is also only $10. Compare that to most venture capital funds which have $250,000+ minimums. In addition, you can see what Fundrise is holding before deciding how much to commit. Start exploring the possibilities today!
Sam,
I would like to share a thought regarding options here that many investors choose to ignore because the media try to portrait that as weapons of mass destruction of wealth. It is nothing further from the truth if one knows how to use the tool.
You can also hedge your S&P long positions by selling at-the-money or slightly out-of-the money calls with some downside protection and not limiting the up side too much. Backtest research has showed that this would provide less volatility to P&L of your S&P long position without limiting the up side. Honestly, I would not pay someone 0.5% fee and tie up the capital for so long to get a risk/return performance lower than the aforementioned strategy.
I have used this strategy for a couple of my long positions, such as McD over the years. I have been selling covered calls against the McD positions to reduce the cost of the shares over a number of years. The call premiums and the dividends I have received over the years have reduce the actual cost of owning the McD shares to effectively zero. The current yield of McD relative to the current share price is slightly over 3%. However, in my case, my yield should be infinite as whatever dividend divided by zero dollars which is the cost of the shares to me is infinity.
Great article. I didn’t know about this product before. Also, I love your blog!
A lot of people posted comments without really reading through your article, and it’s a real shame. A lot of people also seem confused about how options can be dynamically hedged or how banks’ trading desks can do it. Unsolicited advice: I’d write up a couple of blog posts and answer with a short link. Most people won’t bother to follow up, but those people that do are your core audience you’re trying to build up, right?
I personally didn’t notice on the first read that the cost of downside protection includes forfeiting the dividends, it just didn’t cross my mind. After some thinking, the bank is obviously constructing something akin to LEAPS call option, so dividends are just naturally left out. But the marketing materials conspicuously omit that, and it’s absolutely crucial for a layman like myself to understand. This is advertising at its worst.
IMHO it was worth placing it front and center: no free lunch, you pay ~2.25% annual dividend yield and the counterparty risk. For that, you get something less volatile with properties that let you sleep at night. You still lose a lot to inflation, obviously (another think that a layman like myself doesn’t always keep in mind).
The counterparty risk is significant. Lehman Brothers had $18,600,000,000 of those notes outstanding when it collapsed, and it was a 100+ year pillar of the industry. When I look at Citi or JPMorgan corporate bonds, I see spreads well over 1% above riskless treasuries. And I think those bonds may well be overvalued. The 1-2% (and I personally think more like 3%) or so per annum counterparty risk is another portion of your payment – add the 2.25% dividend yield, and the cost of good night sleep is starting to really add up.
I haven’t found LEAPS pricing, but I suspect it’s within that range. The bank can be very efficient in constructing the derivative, so maybe buying the LEAPS call or buying the index and LEAPS put is more expensive. But it would be at least partially SPIC insured, liquid, and generally much more flexible.
I think it’d be worth running some stochastic simulations and showing the probabilities of capital loss and mean expected return in different scenarios, to demonstrate relative costs and tradeoffs between going “naked long” as you put it, buying one of the two notes, or constructing this with LEAPS (or traditional) options.
Lastly, I don’t buy some people’s critique that this is european style option product. So what? European style means much cheaper to buy, and if you exit in the depth of a recession, guess what? You still keep your dollar capital that will now buy you much more stock. So you buy stock – and you’re an all-round winner in that scenario.
Btw it’d be interesting to see how much you lost (or rather, not gained) when you sold the note, comparing to if you just went naked long S&P500 with dividend reinvesting.
And the very last – the critique of Dow30. It’s a horrible index devised before computers that shouldn’t be used to measure anything; but it performs remarkably similar to S&P (which itself isn’t good; it changes methodology and because so many people invest in it, it’s overweight in large caps, otherwise there would not be enough small caps stocks to go around) or Wilshire. That’s because you can just choose a bunch of stocks and weights simply throwing darts – and they will likely perform very similar to the market, given large enough sample. I don’t like Dow but I wouldn’t be overly concerned with its archaic methodology or lack of diversity.
Sounds great. Where are you investing now and what is your net worth composition? Do you work in finance?
Most of my networth is in my business (tech, not finance) , so … I’ve been actively avoiding diversification in that aspect for a while now. Besides that, I have ~400k in 401k and ~400k paid-off house. The 401k would be considered diversified in the sense that I have 20% in intermediate and short-term bonds and money market (mainly to deploy when/if the next market correction happens), 20% in foreign stocks, 20% large caps, 20% mid caps, and 20% of small caps and misc. date-target funds. I arrived at that distribution completely by chance over the years, mostly by haphazardly buying more of whatever I thought was less risky or more valuable at the time, rather than strategically rebalancing, but I think I’m fine with that asset allocation right now, even though the stock market has record-high PE.
However, that’s not real diversification. Yale endowment is real diversified: they have absolute returns, illiquid real estate, and generally assets that aren’t highly correlated to US stock or bond markets.
I’m nearing a series of liquidity events and have to think what to do next, besides I’ve always been interested in business and finance. Eyeing the private equity market now (not as core investment, but as an addition to portfolio in order to diversify and acquire a new skill that may be very useful when managing my – hopefully – future wealth). Crowdfunded Real estate private equity looks particularly interesting to me.
Other than that, I’m thinking about building a value-oriented taxable portfolio after my exit. Fortunately it’s staggered so I’ll have a chance to try with a smaller portfolio at first. I’m reluctant to enter at this PE and I’m very reluctant to manage my soon-to-be-built portfolio myself (having no experience), but I’m even more reluctant to trust a FA because none of them strikes me as particularly bright or having interests that are really well aligned with mine. So I’m considering just giving most of it to a roboadvisor and maybe buying OTM LEAPS put as a bit of downside protection while I learn to manage my own portfolio.
Followup: I didn’t find LEAPS pricing, but here’s a paper about Lehman Brothers notes. In particular, on page 4 they say that the S&P500 100% participation principal protected note, presumably sold for over $100 (including front-loaded commission), was actually worth $89.27 when valued as a combination of zero-coupon note and a long term call option (which is what it was). I want to know this, and also how much it costs to construct the note myself and what’s the insolvency risk before I start thinking about the payout profile of the note and whether it makes sense to buy it.
And I forgot the link to the paper. they give valuations of several derivative notes. They don’t go in-depth with the assumptions of their valuations (implied volatility, interest rate or insolvency risk numbers are omitted) so I guess you’ve got to “trust them”. In any case, I’m assuming their valuations are theoretical, not taking the real-life inefficiencies of a retail investor into account. However, being under impression from reading the paper, I believe they’re right in the sense that you buy about $0.90-$0.94 for a dollar when you buy a structured note from an issuer. The payoff looks attractive on the surface and lets you sleep better, but that’s what those notes are constructed to do – it’s a psychological benefit, not financial. So I’m leaning towards my initial idea of buying the securities outright (and building my ideal value portfolio, not settling for the flawed S&P500 approach), employ some tax-loss harvesting (impossible with these notes), and maybe (just maybe) buy a 10% out-of-the-money long-term european-style put to sleep better at night.
Here’s the forgotten link:
Please poke holes in my thinking, that’s what I’m here for!
Swedroe (whom I’m not particularly fond of, but does respect mind-independent data) said it well:
> If the fiduciary standard of care were applied to the sale of financial products, it’s likely that
> virtually all structured notes would disappear. If a person selling the product cannot
> demonstrate that purchasing it is in the buyer’s best interest, why should that sale be
> allowed? I can’t think of a single reason.
Furthermore, speculating on a 70-page disclosure, complex structured linked product is just begging the wolves to have you as a rack of lamb for dinner. Because that is what you are doing when you say to yourself: “Oh, I don’t think the market is gonna go down more than 30% in 5 years.” based on zero independent and verifiable facts. And lastly, this jewel from Securities Litigation and Consulting Group:
> The spectacular failure of Lehman brothers in September 2008 left investors holding more
> than $18.6 billion face value of what had been previously sold as low risk investments but
> which were now worthless. The Lehman experience is especially instructive of the
> opportunity for mischief presented by financial engineering; faced with increasing borrowing
> costs Lehman stepped up its issuance of structured products where its credit risk would not
> be priced into the debt. The harm thereby inflicted on retail investors was a direct transfer
> from unsophisticated retail investors to Lehman and UBS which co-underwrote much of the
> Lehman Brothers structured product issuance. This transfer from retail investors was only
> possible because Lehman and UBS made the structured products increasingly complex and
> opaque.
This is great. What are you investing in right now and what is your net worth composition currently?
I’m always looking for skepticism because it helps me see the other side before making any investment. It also potentially provides much more upside. One of my best investments was Netflix in 2006. Everybody said it was going to just die. Oh how sweet the ride has been.
I’m also looking for some good investment ideas today. Thx
Hello Sam,
Your article got me interested enough to revisit this product with my banker. He is offering a similar product but less appealing (to me) due to a capped upside. The downside has a 15% buffer (e.g., if the S&P declines by 35%, my loss will be 20%).
Do you have any opinions on these terms compared to yours?
Did you talk about liquidity for your product? My banker says I can sell at any time at the published price but its unclear how that price correlates to the S&P 500.
Maximum Redemption Amount: 146% to 151% of the Principal Amount of the Securities ($1,460 to $1,510 per $1,000 Principal Amount of the Securities), to be determined on the pricing date
Buffer Level: 85% of the Initial Level
Buffer Percentage: 15%
Leverage Factor: 150%
Underwriting Discount and Commission: Up to 4.50% to Agents, of which dealers, including Wells Fargo Advisors, LLC (“WFA”), may receive a selling concession of up to 2.50% and WFA will receive a distribution expense fee of 0.12%
Read the prospectus carefully. My guess is it says something like “a secondary market may develop but is not guaranteed”. there is no requirement for them to make a market for you to sell into, let alone at the price where the note is marked on your statement.
What is the maturity of the note?
It’s a 5 year note and I’ve been told there is a daily NAV. I can sell within one day like a mutual fund but the NAV calculation is not straightforward since it will be based on option pricing and available buyers/sellers.
Sam, some thoughts based on the article & your replies to various comments here.
– I agree with most of your macro outlook, but am a bit concerned with where this note leaves you positioned. Of particular relevance to the terms of the note might be how one interprets current valuations & the autocorrelation of valuation metrics (how long valuations take to mean revert): https://www.hussmanfunds.com/wmc/wmc160926.htm
– I totally get that we can’t know when the party will stop on a high-flying market, and I don’t mean to imply that I or anyone else know where we’re headed. Your point – that structured notes help people from missing out on gains without having to do any complicated options positioning- is a really good one.
– Although the terms of the note you found might have attractive terms relative to notes you’ve looked at in the past due to current options pricing, you probably should recognize that there’s a reason this deal exists right now. The terms might be highly attractive –in general– but may be not so great a deal based on current expectations in the market.
– If you’re so worried about principal protection – why aren’t you willing to give away upside for larger downside protection, given your note’s time horizon?
– By locking up money in an over-valued market, you’re giving away substantial buying optionality in the event of a down-turn. Given your views, why not restrict yourself to cash and shorter duration securities with minimal solvency risk?
– You’ve mentioned that there’s less leverage out there than in the lead-up to the financial crisis…. credit has massively expanded. Where is it all sitting? On a related note… why expect a pull-back of less than 30%, when pullbacks of more than that have been historically common in equities?
– If you’re so worried about principal protection – why aren’t you willing to give away upside for larger downside protection, given your note’s time horizon?
Because I don’t think we’ll correct by more than 30%.
– By locking up money in an over-valued market, you’re giving away substantial buying optionality in the event of a down-turn. Given your views, why not restrict yourself to cash and shorter duration securities with minimal solvency risk?
I am for the money I do lock up. But I spend less than I make, and have a significant amount of excess cash each month and a large influx in 1Q2017 due to an expiring CD and bullet payment on an investment I made in 2009/2010 as part of my bonus.
– You’ve mentioned that there’s less leverage out there than in the lead-up to the financial crisis…. credit has massively expanded. Where is it all sitting?
It’s all sitting in cash. People are cashed up to the gils and haven’t fully participated in this recovery.
What is your background and where are you investing your money?
Hi Sam,
Been following (stalking) your work for a while now. It’s very inspirational so keep it up. I hope I’m not out of line dissecting your investment thesis and hopefully helping some of the other readers.
I’ll try to give a more rounded approach given that:
a) I used to lecture FX Options in university (including level 1, 2, 3 and cross greeks, option models etc)
b) I used to sell these structured products.
c) I’m currently setting up the FX options, fixed income and structured products sales desk for a bank in top 5 global financial centre (sounds fancy but it’s not).
At first, I was hesitant on your product due to the 30% downside protection however I was comforted by the European style expiry. The reason is because I sold a similar product to a client in 2007/2008. Unlike your product, the one i sold was an american style trigger at 35% downside. That means that if the market fell 35%, the trigger is activated. Even if the index rose back to say 90% (after falling 35%), the client would still lose 10% (100% – 90%). Due to the increased volatility, we unwound the position for the client and switched them into a zero bond of an entertainment company. the client was able to redeem the funds in full when the corporate issuer called their bonds early.
The other issue i had was the lack of coupons. this was a deterrent but given the assumption of 7% absolute returns over 5yrs was comparable with your CDs, this also made sense. thus, it’s a flat or mildly bearish market that will cause this structured product to underperform.
With regards to fees, 0.50% upfront is very cheap for 5yr structures. Market standard now days is about 1-2% (in Asia anyways).
To answer the queries of other readers:
1) The bank selling the structure does not necessarily hold the underlying asset, in this case, the S&P 500 Index. Usually banks will offset the option positions away with another bank, unless they want to warehouse the risk ie, the banks view is opposite of the investors. Given decreased proprietary risk taking by banks resulting from the Volker Rule enforced as a result of the GFC, most banks offset the investors positions with that of other investors ie they find other investors willing to take the opposite position and match them to remove their rise.
2) Sales people earn from the fees.
3) If i were to hazard the deconstruction of the product it would be a 5yr zero bond (or 5yr deposit) combined with 1.5x long vanilla calls (strike 100% of spot) + 1.0x short put (strike 70% of spot). Given the option skew is likely to be quite negative at the moment (given the market toppishness), many will be willing to pay for downside protection, thus selling puts earn more premium to fund the 1.5x calls. The alternative is to use reverse knock in puts (at expiry) with a strike of 70% of spot and a barrier of 70% of spot. Note, when you put in your funds eg 100,000, your deposit is not the fully amount. Rather, the bank uses a 5yr deposit rate from example and discounts your future value of 100,000, back to today’s present value over 5yrs. Assuming this is 2%p.a., this is 90,573. The balance of 9,427 is invested in the option strategy. this was what may work entailed today when i was looking at a bullsh call spread structure.
As a banker, sales person, lover of derivatives and financial freedom fighter my advice would be to always understand what you are getting in to. It’s your money and nobody can take care of it better than yourself!
Moreover, I believe that there are different investment products and strategies that suits different people. I went from working in university lecturing fx options, to being an equities anaylst, to structured product sales, to fixed income sales etc. In my career, i’ve looked at all sorts of investment products and strategies. Even today, i was looking at a strategy called risk parity, after reading about smart beta factors and permanent portfolios. The key takeaway is to save, create a buffer and invest.
although i like the structure sam invested in (and given i sell this stuff), i’d more than likely go down the path of a portfolio of index etf’s, with a buffer to cover a large drawdown or go with fixed income inflation linked bonds, simply because that’s what I’m most comfortable with and what suits me the most. this could change, and i could find another strategy that works better, such as smart beta, permanent portfolios or risk parity portfolios, but only God knows.
well, that’s enough dribbling from me. hope that wasn’t too dry and boring and i’ll let everyone get on with their interesting lives.
adios!
Thanks for sharing your background! I wish everybody did this. It really helps me and others understand where one is coming from to be able to respond accordingly.
Very interesting about the American vs. European expiry. Good to know.
Enjoying you career transition? Must be more lucrative at the very least!
What exactly is a “a buffer to cover a large drawdown” mean for you? Cash?
No problems. Hope I can add value to others.
I find options very interesting and intellectually challenging. Besides, Americans and Europeans, there’s Asians and Bermudans as well.
I realized I made an error earlier. The investor actually sells a european (at expiry) reverse knock in (comes alive) put option with a barrier at 70% (100 – 30% buffer) and a strike of 100%. Thus, at expiry, if the index is down 30% or more, the knock in activates the put option to come alive, thus investor incurs the loss.
Yes, the transition is very interesting, though there’s more boring, legal/compliance/processes/documentation work and less fun stuff ie structuring profitable ideas for clients at the moment which is disappointing. Not as lucrative but in it for “the challenge” and experience of setting up and running a business. Will get paid to make mistakes, think laterally, learn to survive and drive p&l etc. should be a good experience for second half.
with regards to the cash buffer i referred to earlier, i previously had “a number” in mind. then i read your post on the retirement amount needed for average salaries. Then i increased “my number” by 30%. anyways, i applied the 4% withdrawal rate and ran random simulations. my concern was a big market decline the moment i hit retirement eg 50%. the second concern was 5years of -10%pa (this is actually worse than a one time hit of 50% due to the time factor). i used random data selected from a pool of historical returns over 30yrs and applied it to my investment portfolio with various asset class weights across stocks, bond, gold and cash. in a nutshell, the results were obvious and were known before the research commenced ie the more i had to invest, the larger buffer i had to sustain a large drawdown. the question i was really trying to answer was how much buffer do i really need and what was the best asset allocation???”
the buffer could be cash or short term money market securities. it could even be a negatively correlated currency. the point however, is to also keep the powder dry so you have ammo when it’s time to pull the trigger. November 22nd perhaps?
I’m definitely planning on having a large cash buffer after the election, just in case. The first debate between Trump and Clinton went better than expected it seems for both parties, but more for Clinton.
Check out this post: The Ideal Withdrawal Rate In Retirement Touches No Principal
The thing w/ my situation currently is that I have two relatively large liquidity events in 1Q2017: 1) a CD expiring, and 2) a 70% remaining payout from an investment I made in 2009. If you add on my current savings run rate and what I have in my money market, I’ve got too much cash. So I’ve got to figure out how to continuously asset allocate.
Sitting on cash is not bad, but I’m just over my limit.
Related: In Times Of Uncertainty, Take Stock Of Your Cash
Hahaha yes indeed. I was watching currencies swing just as they started speaking.
thanks for the link. it was spot on and exactly what i was thinking of doing. i did consider and looked the the possibility of living off the dividend income, which i think alot of people do. the alternative i considered was to invest in inflation linked bonds, so you have the safety with inflation protection so your spending power doesn’t erode. i guess the crux of it at day’s end is how to preserve the capital, yet have enough cashflow to live off, and potentially still increase the capital.
the elections will all be over by november so when your funds come due in 2017, the markets should have less uncertainty. ofcourse, black swans could happen but for the most part, having ammo for 6months to a year could be ideal to take advantage of opportunities that come along. rebalancing the portfolio after the cash inflow is another alternative.
Sam, as usual, great post and very clear explanation of structured products. I had a chance to invest in these in 2007 and am kicking myself for not doing so (yes, lost big during the financial crisis…)
I also read your monthly newsletter and it sounds like your trending toward less content on the site (understandable!). Have you considered allowing for others to post articles to your site? Obviously it would be vetted by you beforehand. But I’d be curious to hear other ideas and analysis after you’ve had a chance to review.
I was trending, but I’m recommitting to 3X a week. It actually often takes more time for guest posts due to editing, feedback, etc.
The main thing with investing is to stick to an investing schedule for a long enough period of time. Wake up 10 years later and be amazed at how much one can accumulate!
Sorry, haven’t read through all the comments, but you said that this was il-liquid-ish. But if you want to participate in this, maybe you can find a secondary market and buy someone’e else’s note at a discount then to get a better deal?
Hi Sam,
My position is:
– 60% cash (a note; all the cash isn’t the same. I have a mix of USD, HK$, Thai Bhat, Malaysian Ringgit). Planning to acquire more Australian dollars via mining stocks, which will result owning more stock.
– 20% gold; 3/4 physical and 1/4 paper
– 5% US short term bonds
– 5% US long term bonds (I need to liquidate)
– 10% mining stock (Again, mining stock is a double age to acquire currency and at the same time to buy in the sector which is undervalue). I own only Australian miners (Australian dollar undervalue). Canadian miners (Canadian dollar undervalue) would do the job as well. American miners not suitable as the USD dollar is overvalued compare to other currencies and gold itself.
So, if you ask me an idea at the top of the market would be:
– Mining stocks in Australia. We all know the wonderful first half of the year the mining sector had. Now the mining sector and precious metals are consolidating which would clear the path for a new uptrend.
If you have an idea how to short the S&P500 for the next 5 years, I’m all ears.
I looked into inverse leveraged ETFs, but seem they don’t do a great job in shorting the market. Also, they are synthetic products which I dislike.
In our last email communication after the Brexit, you mention “iShares MSCI Europe Financials ETF” which I think is an excellent vehicle to invest in a cripple Europe and Financial sector.
Did you buy any? What is your thinking about the European bank stocks? More down side?
SH, SDS, SPXU, and SPXS are easy ETFs to buy to short the S&P 500 as a hedge.
I purchased $52,000 of this note in my wealth management account. Feels good to allocate excess capital and not have to worry about it!
Hi Sam,
thanks for sharing this product. It sounds different from the usual investment vehicles.
I’m not sure I understood fully how it works, however, from my mental calculation, it’s a losing investment.
My angle of statistic is a bit different than yours, let’s compare.
– In the last 100 years, the S&P 500 went through several recessions (22) which occurred between 3-10 years interval.
– The last recession finished in 2009, so now we are in the seventh year of expansion.
– The note maturity is 2021 which is the twelveth year of cycle’s expansion.
So, the possibility to have a recession in the US before 2021 is most probably at 95%. The 5% chance to witness a downturn after 2021 could be considered a “white swan.”
The white swan could be the result of the unprecedented quantity of liquidity the central banks have injected into the economic system in the last 7 years.
Resulting in an overextended new cycle never experienced in the previous 100 years.
From my understandig, the only way to make money with the structure note is to have the S&P 500 above today level, correct?
If yes, there is a 5% of this occurrence to happen (white swan).
Does it make any sense?
Cool. Given you believe there is a 95% probability there will be a recession and are assuming stocks will be lower 5 years from now, are you in 100% cash or shorting the market?
Sam,
You keep asking how people go “naked long at market highs”, but don’t ask the underlying question of what is your age, risk tolerance, total value exposed to the markets, source of other income, etc.
I am naked long, because I have a day job where I save over 60% of my income every month. Furthermore, I don’t have a NW anywhere near yours and therefore am not in principle protection mode (I don’t chase unicorns either). If I was in your position, with your NW, your RE holdings, etc I would be much more like you.
In an above post, I referred to undervalued blue chips, the reason these are of interest to many people is that it produces some income that can be reinvested back or elsewhere while waiting for upside on the stock price.
One asset that I haven’t seen anyone write anything of value on are Muni’s and Muni ETFs. There are lots of us who live in states that don’t have an income tax, therefore these are extra interesting. If in Cali, or other high income tax states then it requires a little more analysis.
One of the keys to being a good moderator is not asking every single question, but to let the community figure things out for themselves. Perhaps I keep asking b/c nobody is answering.
Isn’t it a little ironic that one feels compelled to aggressively invest at all-time highs naked long while NOT being financially independent yet, but also isn’t willing to chase unicorns?
At the same time, someone who is financially independent already can afford to swing for the fences, but doesn’t?
See: Don’t Stop Chasing Unicorns: Money Making Opportunities Are Everywhere
Speaking of Muni ETFs, I just bought some CMF, California Muni bond ETF yesterday.
What percentage of your net worth is in stocks, bonds, real estate, etc?
Related: Recommended Net Worth Allocation By Age And Work Experience
Thanks for writing this. I didn’t know about structured notes before and they look very interesting.
I live in Switzerland and I tried to find similar products but I didn’t get promising results. The only financial institutions that mention them are banks like Credit Suisse and UBS, which are famous to be the first entities to run away from when thinking about investments.
I wonder if any other Swiss reader found better alternatives for investments of this kind.
The bank has no exposure to the market. All risk is hedged. The offer them partly as a “service” to the client, but also as a way for retail brokers to earn fees, for the bank’s treasury to get cheap funding, and for the trading desks to make money. These sorts of products are worth hundreds of millions of dollars a year to each of the major banks.
This is really interesting.
I’m trying to work out the math on the bank/investment company’s side on this?
Why would they offer a product like this for a ~2% fee as you mentioned and that uncapped 50% kicker when markets mostly rise over 5 year periods?
Wouldn’t it be better to just offer super solid 3-7 year CD rates so they can lock in their cost of capital?
Or is this product more done as a service to investors like you where they synthetically create investment opportunities so you don’t take your investment cash to some other investment provider?
Appreciate your explanation on this (I know you have the finance background thats why I’m asking)
Further to the comment below, imagine if they could lock in funding, but at a level even cheaper than where they’d ordinarily issue a CD or note (like 0.30% or more a year cheaper). And the retail broker gets paid, and the trading desk gets paid.
Now imagine doing that with billions of dollars a year and you have a sense of how the structured note/CD market works.
The main thing to remember is the bank has exactly 0 exposure to the market’s move. All risk is hedged. The source the puts and calls and they sell it on to you, at a markup. simple as that.
How do they hedge the downside when there’s “get your money back entirely” unless market drops below 30% (which rarely happens) and yet any positive gain is magnified by 1.5x?
And they gotta pay expenses to said trading desk and retail broker.
Does that 2% dividend sacrifice and the fees on these things make up for the downside risk and the magnifying factor?
I don’t mind doing more research just not sure how to go about searching for this…appreciate you replying.
Brad
Sure, let’s think through the steps.
The bank’s treasury issues a 5 year note. Ordinarily this would pay something like say L +150, and mature at par. The maturity of this note is what generates the “get your money back at the end”.
But they don’t pay you L +150, instead the bank’s treasury pays that value to the trading desk. That 5 year stream of cash flows has a value; that value is used to purchase a call option (generates an upsize), and the end user sells a put to the desk (bc they’ve bought a note which can lose some percentage of its value if the market declines).
In 5 yrs, the note matures, and you get your principal back, adjusted for any gains generated by the calls (positive to the client) or losses from the sold puts (negative to the client). The piece a lot of people dont see is the bank paying its internal trading desk its funding level, instead of the end investor (who has given up the L +175-180 they’d ordinarily get in exchange for getting the equity linked payout).
Does that make sense? The bank has no risk. they’re giving you a zero coupon note, and a package of calls and puts they can source in the market. As an analogy, if you bought an ETF that delivered 90% of the S&Ps upside, but 100% of its downside, can you see how the provider never loses money? They just buy an ETF in the market and pass through less of the returns to you.
Would you care to share which part you are buying the multi family in? I also feel California is not the state to buy real estate any more.
Right now I am investing in northern Utah. But I also have friends who are having a lot of success buying in places like Memphis, Atlanta, Kansas City… places where cash flow is commonplace ;)
I will be turning my current home into a rental at some point in the future, but I have no desire what-so-ever to by any residential investment properties in CA
At this point I am 100% out of the stock market. When you are regularly hearing “Dow closes at a new all time high” every other week on CNBC, Bloomberg and Fox Business, that should be enough to tell you that it is definitely time to sell, if you didn’t already get out a while ago. Everybody knows to “buy low, sell high” but for some reason not many people seem to have the discipline to actually do this.
I like the “pay down debt” investment. It is hard to go wrong paying down debt… ESPECIALLY if you have consumer debt…. all it is doing is costing you money and eating up your cash flow.
I think a great investment right now is buying income properties in locations that are not in bubble territory… good cash flow areas like the midwest and the south. I live in California, but I probably would not buy a property in California right now. However I am currently under contract on a multifamily deal in another part of the country where properties do not seem overvalued, and you can realize solid cash flow. I may not see double digit appreciation this year like I have with my personal residence, but I am 100% ok with that since this new property will be another source of passive income for me.
Sam, do you know what they do with the money after you buy the structured note? Are they combinign bonds+derivatives using your and other clients’ cash? I wanted to better understand how it works. Thanks.
The money you pay goes to the bank’s treasury to fund whatever operations the bank is involved in. The mechanism is roughly like this.
Structuring/trading desk approaches sales to gauge interest in a specific note/payoff (or they may just make an educated guess based on whats trading in the market). Once they figure they’ll have sufficient demand, they go to their internal treasury and check where they can receive funding for the 5 year (or whatever term of the note). Let’s use L + 150 as an example. Since they pay no actual interest to the investor, the value of this funding is where the note’s value is derived. L +150 for 5 years is worth something like 13.5% of the face value. The value proposition to the bank’s treasury is that if they pay an interest of L + 150, they probably would have had to pay L + 180 for a benchmark issuance. so they have a saving of 20-30 bps running.
The structuring/trading desk goes out and figures out what the cost of the various puts and calls are to generate the payout. They’ll assume they have say 10.5% of the 13.5% the funding is worth to spend and they’ll construct a payoff and figure out what leverage on the s&ps upside they can offer. That leaves 3% pnl for the firm. They pay the FA/broker 0.50-1.5% and keep the rest as trading pnl.
And that’s more or less how it works.
Hey Sam,
This was a really intriguing post! Is there an assets managed minimum to get offers for structured notes? You mentioned private client/private wealth management and when I did more digging it seemed like you have to have $5-$10 million managed by the bank to qualify for private client services.
It’s not that much at the mainstream banks i.e. $250,000. Also, you can open up a brokerage account and have someone be your liason from the bank and NOT pay any of the ongoing asset management fees.
I just have my guy e-mail me once a month with ideas that look interesting to him that fit my investing desires. And then I’ll do more research on them or pass. This was one of the ideas presented to me that I vetted.
Let’s hope I didn’t literally top tick the market when I published this post! But hope all is good five years from now.
Thanks for the great article. My dad invests in stocks… and stocks only. He is fairly diversified with maybe 40% cash but I worry about him losing his shirt should the whole market decline. He says he prevents major losses with “stop losses.” Am I correct that these are not guaranteed? And if the market dropped by 50% in a day I think the brokerage’s “promise” to sell ASAP is pretty weak when everyone is SELLING. How do I prove to my dad (who is nearing retirement) that stop losses are worthless in a major downturn? I need to talk him into something less risky to protect his precious retirement savings. It is a naive trap to believe that earning positive returns in a bull market will translate to the same in a bear market.
It’s not a “promise”. There are stop losses, and there are stop limits, but basically what happens is that once the stock or market drops a certain amount, the stock will be sold at whatever the prevailing market price is. you’re right, in a big drop the price may gap down further and he’ll have losses in excess of where he expected to be stopped out.
Use close only stop losses. Kudos to the dad for actually using any as 99% of investors don’t at all.
Rather than structured notes it makes more sense to me, to invest in real estate rentals where can get 12%-20% return per year. This is assuming you manage the rental yourself and you buy in certain part of the country. I know this type of investment is not for everyone but you can get a property management to manage it for you. Even with a 8%-10% management fee, it’s a much higher return than your structured notes strategy. I know you will NOT get such returns in San Francisco but there are plenty of cities, where such returns are possible.
For example you can buy a 4 plex for around $140k and get a monthly income of $3k – $3.4k. Your monthly expenses will be about $1k leaving you $2.4k * 12 = $28.8k per year, which is about a 20% return. I am assuming there is no mortgage on the property. I personally, am transferring my equity out of California real estate and buying in other states, using this strategy and will attain my goal of financial freedom very shortly. This will only take me a few hours per week, to manage the rentals, which is far better than full time working for some company. My ROI will also be far higher than my current California rentals. I live in S CA. I see this as a double win, for my money.
Sounds good to me. Check out my Real Estate category where I’ve written a ton about real estate investing over the years. RE makes up about 40% of my net worth.
Also check out real estate crowdsourcing as an investment opportunity. I’m doing more work on this space now that it’s be 4 years since companies have first operated. I’m looking in the South, MidWest mostly for those returns you speak of.
For reference, investing in public equities (including structured notes) makes up about 25% of my net worth. But there are good ideas in all asset classes all the time, so I’m doing my best to cycle through them all.
My concern with PPNs is the opacity of the fee structure and the underlying investments. They’re not required to provide those details and when it comes to investing, if I can’t see what’s going on under the hood, I tend to run the other way. Also, if the company goes under, you have no protection. So it’s not as “safe” as it seems.
If the concern is investing at the top of the market, what about using dollar cost averaging to smooth out the ride instead of dumping all 100K at once? Or using a more conservative asset allocation?
I don’t think the note is that complicated, as illustrated by the chart. There are notes that cross-link different asset class performances with capped upsides that are much more confusing. This one is about as plain vanilla as it gets. But, I can understand why it can be confusing.
When you mention 100K, it’s all relative. 100K is part of the dollar cost averaging range ($50K – $200K) I’ve been deploying in each note since 2012. I have extra savings, and so long as I’m spending less than I’m making, I will continue to have excess funds to invest just like everybody else.
This note is interesting b/c I sold about $53,000 in profits from a 100% participation note that was up 35% since mid-2012, and I’m just rolling over the proceeds to this new note with 150% participation and a 30% barrier. The note from 2012 also had a 20% barrier, but that barrier will probably never need to be utilized since it’s so far down.
Is there anything in particular you are investing in right now?
Yeah I have no idea what you’re talking about. Good thing you know how to analyze those things because those look too esoteric to me.
I’m using a 60/40 portfolio, mostly low-cost index ETFs with some preferred shares, REITs, and high-yield bonds mixed in. It held up pretty well during the 2015 oil crash in Canada. Kept paying us dividends the whole time even when the capital value took a hit. Nothing too fancy. We’re Indexers at heart.
Sam, thanks for the post. This is a very naive question – how do you find out what structured notes are offered on the market and through whom? Is there a “directory”?
Hi Mrs. Roos, you can ask at your local bank branch or go online. A reader highlighted this website in the comments: https://www.citifirst.com. Click North American -> Private Investor.
The more you explore, the more you will learn! This post’s primary purpose is to increase our investing knowledge base and have a discussion on what and how people invest when the stock market is at an all-time high. We are in unchartered territory here.
I’m investing in senior housing real estate companies. I am not bullish on most real estate investments, but the senior housing niche is attractive. You need to do your homework and make sure the owner/operator has a strong track record. But with an aging population of baby boomers, there is still upside for the next decade or more.
I agree with the senior housing real estate business. Demographics are getting old and we are living longer!
What exactly are you investing in? I’m very intrigued if there are publicly traded ETFs or other vehicles that invest in such projects without needing to put a huge amount of money.
I outlined the terms of the specific investment on my site
In that this is still an open private placement, if you are interested, I’m happy to discuss the specifics with you offline.
As far as publicly-traded senior housing REITs, the one I’m most familar with is HCP (NYSE: HCP). It’s priced a little high after a nice run the last few months, but still has a strong dividend yield. They’re well capitalized and are one of the biggest players in the industry.
This was an excellent explanation. You have a real gift for clarifying complicated investments. My built-in hedge is investing in a skill that will increase my earning power substantially. The skill can’t be taken from me, and will likely be valuable on the market for at least 10 years. The potential earnings from the skill in that time are $1,600,000 before taxes at current rates that should hold steady and potentially increase due to scarcity.
Also, definitely read the fee disclosure, and especially the “fair value”. These are not the exact same thing, but on some long dated notes, I’ve seen scenarios where the note is sold at 100, but the “fair value” net of all commissions and bid/offer is in the low to mid 80s. Now, this is a bit like valuing a car at it’s scrap metal value, but something to bear in mind.
OK, thanks for sharing. There is a wider bid/offer spread if you plan to sell before the term b/c it is not a liquid secondary market. So again, folks need to be willing to lock up their money for the duration of the term.
CUSIP / ISIN: 17324CAG1 / US17324CAG15
Let me know what you find out.