Investment Ideas At The Top Of The Market

Looking for investment ideas at the top of the market

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:

  1. Are afraid of investing in the stock market at all-time highs
  2. Want to know how to invest in hedged investments
  3. Invest for the long term
  4. 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.

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.

S&P 500 Structured Note Investment

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.

S&P 500 Index Barrier
If by Sept 2021 the S&P 500 closes below the red line, you lose by the exact amount of the decline. The red line is the 30% barrier.

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.

S&P 500 valuations

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 Personal Capital 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

Looking for new investment ideas? Explore real estate crowdfunding. If you don't have the downpayment to buy a property, don't want to deal with the hassle of managing real estate, or don't want to tie up your liquidity in physical real estate, take a look at Fundrise, one of the largest real estate crowdsourcing companies today.

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.

Sign up and take a look at all the residential and commercial investment opportunities around the country Fundrise has to offer. It's free to look.

Fundrise Due Diligence Funnel
Less than 5% of the real estate deals shown gets through the Fundrise funnel

Invest In Private Growth Companies

Finally, consider diversifying into private growth companies through an open venture capital fund. Companies are staying private for longer, as a result, more gains are accruing to private company investors. Finding the next Google or Apple before going public can be a life-changing investment. 

Check out the Innovation Fund, which invests in the following five sectors:

  • Artificial Intelligence & Machine Learning
  • Modern Data Infrastructure
  • Development Operations (DevOps)
  • Financial Technology (FinTech)
  • Real Estate & Property Technology (PropTech)

Roughly 35% of the Innovation Fund is invested in artificial intelligence, which I'm extremely bullish about. In 20 years, I don't want my kids wondering why I didn't invest in AI or work in AI!

The investment minimum is also only $10. Most venture capital funds have a $250,000+ minimum. In addition, you can see what the Innovation Fund is holding before deciding to invest and how much. Traditional venture capital funds require capital commitment first and then hope the general partners will find great investments.

About The Author

206 thoughts on “Investment Ideas At The Top Of The Market”

  1. multimillionaire

    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.

  2. Arm The Lawyers

    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.

      1. Arm The Lawyers

        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.

      2. Arm The Lawyers

        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.

        1. Arm The Lawyers

          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!

  3. MachineGhost

    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.

    1. 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

  4. 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%

    1. 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?

      1. 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.

  5. young_analyst

    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):

    – 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?

    1. – 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?

  6. 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.


    1. 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?

      1. 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?

        1. 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

          1. 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.

  7. 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.

    1. 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!

  8. 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?

  9. 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?

    1. 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!

  10. 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?

    1. 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?

  11. just a thought

    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.

    1. 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

  12. 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.

  13. 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.

  14. Brad Spencer

    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)

    1. 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.

      1. Brad Spencer

        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.


        1. 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.

  15. NM-RealEstate2016

    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.

    1. Middle Class Millionaire

      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

  16. Middle Class Millionaire

    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.

  17. TheMoneyHabit

    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.

    1. 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.

  18. TheMoneyHabit

    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.

    1. 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.

  19. 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.

    1. 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.

      1. MachineGhost

        Use close only stop losses. Kudos to the dad for actually using any as 99% of investors don’t at all.

  20. NM-RealEstate2016

    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.

    1. 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.

  21. FIRECracker

    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?

    1. 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?

      1. FIRECracker

        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.

  22. 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”?

    1. Hi Mrs. Roos, you can ask at your local bank branch or go online. A reader highlighted this website in the comments: 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.

  23. Financial Slacker

    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.

    1. 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.

      1. Financial Slacker

        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.

  24. 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.

  25. 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.

    1. 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.

  26. This is some thing I might be interested in. I like the setup and sure I do not mind the extra fees vs index ETF, if that means I am getting downside protection with meaningful upside capped returns even.

    My only issue would be, this sounds like some thing I would need to meet with a bank representative in person to set up. Which won’t be easy considering I barely spend a month in the US and rest of my time in the year is overseas working.

    Will do more research.

    1. Uncapped returns you mean. A lot of notes I’ve found cap returns. This one, with a 1.5X kicker uncapped is something I haven’t seen before. It’s also a sign that banks must create better incentives when the market is at all-time highs.

  27. You can construct a note like this yourself, minus the fees, out of the traded underlying derivatives (calls and a put spread).

    Fees in this note could certainly been 3% or higher. There are fees in bid/offer and trading pnl which are not included in the hard dollar commission that your broker earned (though that also may have been 3% or more).

    Banks make money on these not by taking any kind of view of against the customer, but by figuring what it costs to generate the payoff profile (ie the sum of the options) and subtract it from much they save from issuing X year unsecured paper at a zero coupon (eg L+150 for 5 years is worth Y). That’s the game for them.

    The value to a retail investor is that you may just want to pay the fees to have someone do it for you, or if the specific payoff structure (like a basket of EM currencies) is not available in retail size. the downside is that you pay fees and have unsecured risk to the issuer.

      1. Ok, but see at the bottom of pg1 in small print where they say the estimated value (ie accounting for internal bid/offer, but pointedly NOT for wider secondary trading spreads that this would in fact price off of is $950, ie 5% fees. Add in the secondary curve and thats probably another 2% (40 bps running for 5 years, just as a guess). So the bank is creating a security worth, at full bid/offer cross, something more like 93%, but selling it to you at 100%. the FA/broker only gets a hard dollar payment of 0.50%, that’s true but doesn’t incorporate any of the internal fees you’re paying to the structuring/trading/treasury desks.

        1. Good stuff. Will the fees matter if one holds for the 5 year duration as intended? For example, let’s say I invest $200,000 and the S&P 500 is up 20% in that time period. Based on your understanding, will I not be getting $260,000 minus $1,000 in 0.5% fee from $200,000?

          1. You’ll actually get the full $260k (ie the $1k was embedded in the note, not paid at the end). You lost out in that if you hadn’t crossed the full bid offer and the market had performed the same way you may have wound up with $280 or 290k.

            Said differently the note paid a full 150% of the upside, but without fees or by creating this yourself you might have been able to get 170-200% (would need an options pricing model to figure the exact value out).

            In your experience does a wall street bank ever sell a five year product (and would an FA ever lock up money for 5 yrs) for a measly 0.50%? ;-)

            1. Great. The thing is, I don’t know how to create my own structured note properly or have the time to do it. If I can get $260K back from $200K in 5 years after the market goes up 20%, I’ll take it!

              I think I underestimated the break even probability of -30% to +7.3%. Instead of a 20% chance, maybe it’s more like a 50% chance.

              I admire all people who go naked long when the stock market is at an all-time high. I’d love to hear how people get the courage. How about you? What are you investing in, how do you get the courage now, and what do you do?


            2. I’m actually playing it safe. fair amount of cash, blue chips with covered calls, and preferred stocks if i can find any with reasonable yields. my view is rates are low for a long time.

              1. I like playing it safe here. But as they say, no risk, no reward. Are you in your capital accumulation phase or have you already achieved your financial nut to live off?

                A lot of people who are in the accumulation phase often ask what they should do in times like these. What would you say to them?

            3. I am still in the accumulation phase. I think the market’s expected return over the short term (next 5-7 years) is likely to be flat or negative. Over 30 years it’ll probably do something like 7%, so it depends on your time frame.

              If you can invest in solid companies that pay dividends that are likely to be maintained, and get a bit of a boost from appreciation then that seems like a good outcome at these levels.

  28. Hi Sam,

    I love these type of products as I to am in principal protection mode. I called our local Chase bank and they told me this particular note was only available to institutional clients. I’m playing phone tag with Citibank. I also buy equity linked CD’s with a portion of my “Can’t Lose Money” like my daughters college fund.

    In these particular investments the number 1 feature to me is the downside protection. I’m more than willing to give up some of the upside to protect on the downside.

    Excellent article,

    Thanks, Bill

    1. Hi Bill,

      Nice to know. Downside protection really is what many investors in such notes are after. We’re looking for a hedge since we’ve been through so many cycles already. Yet it’s funny how the public really tries to bash the living hell out of anything they don’t fully understand. Well, the structure is not that hard to stand if you just take the time to understand it. Don’t be burning innocent women at the stake because you think they are witches.

      Open your mind folks! Spend some time learning about various investments.


      1. Sam, I gotta chime in here because my only curiosity about these notes is still unanswered (unless I missed you answering it in another comment). How does the bank make money on this?

        Last time I asked this you accused me of having an “us vs. them” mentality and not understanding things. OK, that’s perhaps true, but no explanation was offered. You have the background to understand this, so could you explain?

        I understand they make money on fees. But how is this a profitable product for the bank if the S&P is in positive territory by maturity? Nobody seems to be answering that. And at the end of the day, a bank is a business and a business is in business to profit.

        What’s going on in the backend to make this a profitable product for the bank?

        1. Besides the half a percent fee, a bank uses the deposits to reinvest to make a spread.

          When you go to the bank and deposit your paycheck or a check, you will get an interest rate of no more than 0.2% in today’s interest-rate environment. The bank will then go and make loans to small business owners, or different deals, and make an interest rate of greater than 0.2%. This is called the net interest margin or NIM for short.

          Based on your question based and background, I’m wondering if most people do not understand how a bank works? If so, this may be a good opportunity for me to write a post about the banking system. Perhaps it’s because not enough people save money or go to the bank to borrow money for loans that they do not see the spread?

          I often take for granted the finance knowledge that I have and assume that other people understand the finance basics as well. So this is something that I need to work on as a writer to help explain concepts, and investments more appropriately.

          Thanks for your feedback and anymore if you have it

          1. I get the basics, Sam… that’s apparent from my earlier comments. I find it a bit condescending that you’re questioning whether I know how a bank works or not.

            What I don’t understand “works” is paying you out 1.5x any S&P appreciation. How does THAT work when a bank’s spread is so low? Borrowing at .2% (from depositors) and loaning at 3% (give or take) just doesn’t get there, clearly.

            So from where I’m sitting the bank is either a) conducting far riskier investments to make sure they’re getting a return assuming your note is redeemed for 1.5x, or b) far more of those notes folks are buying do not result in a favorable outcome for the note purchasers (unless you consider getting your principle back a positive outcome… which I’m sure some people do).

            I feel like I’ve said this several times now, but still can’t get an answer. I’m not saying you owe me one, but I find it perplexing. Have you considered this before investing in this note?

            1. Sorry, I don’t know how to explain how it works any better than the post and the comments. I don’t know what else to say but to meet up with someone who creates structured notes for a living and ask? You can hedge out almost all of your risk and lock in gains if you act as an agent.

              I could call you to try and explain to you the back end more clearly. But let me go play some tennis first. E-mail me your availability and I’ll try to help explain.

              I’d love to know how your edtech company makes money in exchange. Thx!

            2. Geppy, I posted an answer further down, let me know if that explained things or if I can help explain any other specifics.

  29. Sadhish Siva

    Very interesting read. My question is, if there is such concern about downside, wouldn’t a simple solution would be to invest in something like a total market index etf and just have a trailing stop loss at whatever comfort level you want (20%, 30%, etc)? Granted you don’t get the 150% upside in your example, but the advantages you have with this strategy are that: you get dividends (which if reinvested can increase gains even more), liquidity (can sell without some bank penalty fee), you don’t have to pay bank fee/sales commission.

  30. This sounds like a fantastic note. If I had a huge nut, that I could, probability speaking, make 4% a year and withdraw 4% a year and live on it, I’d never work another day.

    I feel like the market is absolutely about to contract. I know the banks are now saying the Fed isn’t going to push rates up (I think GS just said we only have a 42% chance after the jobs report), but reading some of the other material — especially some of the data coming out of the St. Louis Fed – I just feel like it’s about to go down. Thusly, I’ve started playing a few more bearish option spreads into my mix and going with longer expiration than usual.

    That said, the likelihood of you maturing 30% below today is unlikely. I’d say you just got yourself a guaranteed asset.

    1. No guarantees unfortunately. But I am impressed with so many people who are wiling to go naked long the stock market at current levels. I’m also impressed with people who have a large majority of the net worth in public equities too.

      My risk tolerance is not that high anymore. I need a hedge b/c my #1 goal after spending all these years building my wealth is to not lose principal.

      Related: Investment Strategies For Retirement Based on Modern Portfolio Theory

  31. Saw this today, and thought it was timely:

    “Wall Street’s Latest Retail Fleecing Product Exposed – Structured CDs”

    1. Speaking of Zerohedge, it does a GREAT job in making lots of money from the public for those who want to learn how to build their online media companies. Check out this amazing article by Bloomberg reporting on how the ex-hedge fund manager was able to create Zerohedge. Such good reading!

      And then Zerohedge’s rebuttal for some more popcorn reading stuff. Oh how I love the online publishing business!

      Here is the original WSJ article:

      Bottom line: some of the structured CDs helped people, and some provided hardly any return b/c the baskets of securities they were tied to didn’t perform well. When you link a risk-free CD to a risk-based asset like volatile COMMODITIES and don’t hold to maturity, of course you could lose money.

      A CD is for allocating risk-free money as part of your net worth. Just buy a CD if you want risk-free money. Things get very complicated when you start mixing different securities together. The note I write about in this article is pain vanilla linked only to itself.

      1. Sam, ZH is an interesting beast for sure. I’ve read both the articles you linked to, and I generally have mixed feelings about ZH. Most of their stuff is hyperbole and fear mongering, but there are some nuggets… you can’t take that away from them.

        The thing that doesn’t sit completely right with me about these structured notes is the banks aren’t dumb, right? Hmm, well now that I typed that, I realize how I maybe don’t fully agree with that :-)

        But banks generally look out for their own self interests, not yours. So why is the bank offering such an investment? Can they hedge the risk of you “winning” and make money on the up-front fees? As far as I can see, that’s what they’re doing. And if that’s the case, wouldn’t you “lose” more often than not? Lose being defined as simply investing in the S&P 500 and coming out better than having invested in the note.

        At the end of the day, the structured note is a product the bank is selling because they believe, or know, they can make a profit on it. Unless that’s inaccurate, one would only be buying that product if the fear of lose of capital was greater than the fear of missed return.

        1. The banks’ benefit in that they get your money to reinvest in what they believe can make them a bigger investment, risk-adjusted. That’s what banks do. They take deposits and reinvest. The media and the government have done a marvelous job in creating a “banks versus the people” mentality.

          Let’s turn things around. You have a startup. Explain to me your proposition and why a client would want to trust and use your product over an existing competitor with a longer track record? How do you convince your potential new clients you aren’t just trying to profit on them, which, you need to in order to survive to get to your next round of funding or become operating profit positive?

          My biggest fears about the startup community is what happens when funding dries up? Too many businesses are running their operations based off funding instead of generating profits.

          1. Sam, I’m not a banking expert by any means but my impression is their margins aren’t huge. They loan money at a higher rate than they borrow it, essentially. So it’s all about how big that spread can be, right?

            Well, if they’re offering you 1.5x participating with unlimited upside. How are they beating the S&P 500 by more than 50% consistently? That’s the question I suppose I’m asking because their worst case scenario is that you get that 1.5x. A much better situation for the bank is that you end up with only your principle back. Unless I’m missing something (could be).

            In terms of my startup… we ARE trying to profit from our customers. What business isn’t? But we do so by providing a service that gives more utility than the amount they are paying. The service is more valuable to them than the money they spend.

            And that’s what I’m driving at (perhaps terribly so) with the structured note. What’s the utility you’re getting by purchasing the product? There’s the hope for outsized return. But perhaps the bank has done a better job of calculating the potential that that hope is actually realized. And if so, then your left with the utility of simply not losing your money. And there are other ways to get that with downside protection.

            Don’t get me wrong, I think the investment is interesting, but I’m just trying to figure it out from the bank’s perspective. Mostly, if the market goes up 100% and they pay you out 150% where do they make money on that deal? If the answer is, “they don’t”. Then why are they offering this note?

            Regarding startups and funding environment… yes, it could dry up and it will most definitely be interesting when that happens. It hasn’t yet. Regardless, like you I will be an interested spectator. I’ve seen plenty of my friends get trapped in the “always raising the next round” cycle, and chose to remove us from that equation. We’re now profitable and still growing nicely. I actually take some pretty insanely high interest rate loans out to supplement growth. Not because we need them, but because we want them.

            I prefer them over equity, even with the high interest (talking like 30% APY type of stuff) because a) they’re non-dilutive, b) I can get them in < 5 minutes, and c) I don't have to deal with more investors :-)

            But overall agree with your last sentence.

            1. I think you may be confusing acting as an agency versus acting as a principal.

              Again, this is the “us versus them” mentality in order for a client to win, a bank must lose.

              Keeping on asking questions and being skeptical of everything. This is a good trait.

              What does your startup do?

            2. Seems I’m unable to reply to your last comment… maybe our exchange got too long for it to handle it.

              Not sure what the difference is between an agency and principal. So you’re probably right.

              We’re in the EdTech space, that’s all I’ll say because I prefer my anonymity.

            3. Have written a longer answer below but the long story short is if they can package and sell you the call options for less than they would have paid in funding for the note they’ve issued they can both deliver you the upside exposure (via the call) and make money (via the savings on the deposit).

  32. I invested in Morgan Stanley structured notes in 2006/2007. One was built based on a basket of commodities (light sweet crude, wheat, and?) and the other was built based on emerging market currencies (Brazil, Russia, India, China). Both had downside protection where you could not lose principal.

    I don’t know remember exactly how the underlying baskets performed over that time, but the end result was that I got my principal back on both investments after the financial crisis, less fees. I think they had 5 year maturities.

    During the financial crisis, their value dropped over 80% for an extended period of time since no financial institution appeared safe from failure. And they had zero liquidity. And you had your money locked up rather than be able to DCA into a falling stock market (true for CDs as well).

    I guess banks are stronger now. But do we know for sure??? ;-) How much have they lent to the oil companies? What is their current leverage ratio? Only the shadow knows…

    1. Perhaps we are in a house of cards II! Who knows. I doubt it, but you never know.

      Folks don’t realize this either, but I think even CDs decline in principal value until maturity. Banks just don’t bother to adjust the par value b/c they promise to return 100% + interest.

      When there is no liquidity or little liquidity like these securities, there will always be a discount until maturity unless the stock market is just so far beyond the capped value or initial strike.

      For example, if you bought a DJIA note in 2012 that had a CAPPED upside of 24%, but we’re in 2015 and 40% higher with 1 month left until expiration, the the note will probably trade at a nice premium to initial value b/c the chances of the DJIA collapsing by 16% in this time frame is very small.

      Shadow out

  33. NM-RealEstate2016

    Rather than buying 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 an income of $3k – $3.4k. Your expenses will be about $1k leaving you $2.4k * 12 = $28.8k which is about a 20% return. I am assuming there is no mortgage on the property. I am currently in the process of transferring my equity out of California real estate and buying in other states, using this strategy. I will attain my goal of financial freedom very shortly. This will only take me a few hours to manage my rentals per week, which is far better than a full time working for someone. My ROI will also be far higher than my California rentals. I see this as a double win, for my money. What do you guys think?

    1. Hi NM, can you please share which states are you investing in? I’m curious about this since my husband and a good friend are thinking about investing in multi-unit properties here in California but we haven’t found the right property with the right cash flow scenario. Are you managing these rentals from afar? Thanks!

      1. NM-RealEstate2016

        Try PA, RI, IL, IN, GA as a partial list of such states. Just be careful to invest in good Neighbourhood. My personal best state is RI and 2nd best is IN.

  34. Sam, I’m a bit surprised you think this is a great investment given your knowledge of the investment management industry. One thing you know for sure is that your expected return here is going to be less than with a straight equity investment. There is simply no way banks are going to lose money here. They are hedging out the market risk and keeping something for themselves.

    In addition to the .5% entry fee, the lost dividends are where you are really taking the hit. Assuming 2.25% dividend yield compounded for 5 years, that is 11.8% return you are giving up. Also, if you really want to hedge against a major decline, this doesn’t do it. If preservation of capital is your goal, then what you would really want is to hedge against a market crash. The problem here is you take the full hit if there is a crash with the market down more than 30% in 5 years. Plus you lose the dividend payout, which likely would be even higher than 11.8% because it would have been reinvesting periodically into a declining market and dollar cost averaging down.

    If you are worried about a potential large market decline, you are better off going long the market and purchasing long-dated out of the money puts at historically cheap prices with today’s low VIX. The bank on the other side of this trade is not dumb and not taking a loss.

    1. Sounds good Linus. I think this is an intriguing investment, not a slam dunk great investment, hence the analysis on the bull, par, and bear scenario.

      “One thing you know for sure is that your expected return here is going to be less than with a straight equity investment.” – Can you explain this further? If the S&P 500 goes up 100% in five years and provides 2.25% annual dividends to yield a ~112% return, how is that performance better than this note that provides a 150% uncapped participation? The return would be 150% versus 112% return naked long.

      I’m very curious to know what investments you are making with the markets at all time highs. I’d love researching new ideas and learning new things. How is your investable assets broken down by percentage? Thanks for sharing!

      1. Sam, I am referring to your “expected” return. Obviously there are some cases where you would do better with this note. But there are a lot more cases where you will do worse. Your expected return (not knowing what will happen to the markets in advance) is lower than just buying the S&P index.

        I personally am long about 60% equities, 30% gold, and 10% cash. I will rebalance further into equities upon any large declines.

        1. Got it. This position will be less than 3% of my investable assets. I don’t know why but it seems like some readers think that this investment is taking up a large portion of my investments. Maybe I need to make things more clear. Or maybe readers are just assuming?

          I don’t like taking a greater than 5% position anymore in any single investment. 3% sounds about right for my risk tolerance. How about you? Can you sure how much you are investing in the amount you are managing?

          I’m thinking of just using percentages in the future so that people can just assume whatever apps the dollar figure they want.

          1. My net worth is probably about the same range as yours judging by the hints you have given. I live in Manhattan and rent and have no real estate exposure at the moment. Like you I can also work from anywhere and am considering a move to SF actually.

            1. Slow and steady. I’ve had an internet marketing business for the past 15 years and have been an active investor over the same period.

  35. The way I am reading this is that you win at greater than 7.5% return on the S&P and between a -30% to -11% loss on the S&P. If the S&P is down more then 30% you lose, of its down less than 11% you lose, if it’s flat you lose, and if it’s up less then 7.5% you lose. That’s a wide range of losses though in each lose case you are limited to only losing out on the dividends and the fee (is the fee one time or yearly? These numbers are assuming one time.)

    I haven’t looked into structured notes before but this is an interesting bet you’ve presented, especially given the uncapped up side. Do you have a link to this note?

    1. A loss or not making the guaranteed risk free rate of return over the 5 years?

      There’s no link to this note. It’s an offering Citibank created.

      The fee is one time 0.5% on the amount you invest.

      1. I was looking at it in terms of a loss compared to just investing in an S&P ETF. My main concern is that if I were to bet on what bucket the S&P would end up in 5 years it would be between -11% and 7.5%. Will have to look more into structured notes though as the limited downside in some cases is very intriguing.

        Thanks for changing your stance on sharing investment vehicles you are considering investing a significant amount of capital in, I love having new ideas on what I should learn more about!

        1. No problem. I generally like to keep my investment ideas private because 1) I don’t want people investing in what I invest b/c they might be in a totally different financial situation than me and don’t understand all the pros and cons 2) everybody comes out of the woodwork to criticize (which actually great to make sure I’m not missing anything), but it can get annoying if the criticizer doesn’t offer any alternative ideas instead.

          What are you investing in currently and why? Thx

          1. I’m a boring investor right now (broad index funds and cash mostly) but with the market so high I’m interested in learning of new alteratives to deploy more cash. A few months ago I purchased my first stepped CD but rates aren’t as good now and it’s callable so if it’s called would like more ideas on where to put the money other then my default of cash or broad market ETFs since I’m more bearish then bullish on the short/medium term on those options.

  36. Interesting. Assuming risk free rate = 1.2%, 20% implied vol, 1825 days to expiration, div rate 2%, an ATM put is valued at 18.2%. Assuming risk free rate = 1.2, 13% implied vol, 1825 days to expiration, div rate 2%, a 20% OTM call is valued at 3.96%.

    So selling 1 ATM put and buying 1.5 OTM calls gains 12.26%. You need 3% compounded for 5 yrs to get to 30% which is your downside protection and takes care of the first 20% upside in the index. Outside of that range you take 100% losses on the put or 150% gains on the call.

    However, if the index moves less than +/- 30% you leave money on the table. It’s essentially a free-ride for the bank that the market won’t move much. Since the vol is low these days maybe that’s why the deals look better.

    I got the options values using a calculator with volatility values for SPY @220/245 which only goes out to Dec’18. If you can get those prices consider doing it yourself and not leave anything to the bank.

    1. Looking at my own comment, I realized I made two mistakes. 1) I should have used the 1-yr treasury rate (0.61%) as the risk free rate. It makes the numbers better, making 30% reachable with a 5-yr CD @ 2.4% simple.

      2) The critical range should be +20%/-30% on the index, corresponding to + 30%/-0% on the note itself.

      Selling an even more OTM call will cap the upside with higher credit on the initial trade.

      My bigger objection to this product is the loss of optionality, rather than the money on the table with realized low vol.

      The bank will likely use index futures/options. I could only find quotes for CME:SP out to Dec’20. Those more knowledgeable please comment.

      1. This is some good analysis. Do you have confidence in structuring your derivatives to replicate a similar scenario every year for five years? If so, how much do you think it would cost to build and how much time would you have to spend?

        Do you often invest in derivatives? What investment platform do you use and what are you invest in currently? Perhaps selling some calls to collect the premium is a good strategy today.

        1. Sam, My proposal is to start with 5-year options at the on-set hence 1825 days to expiration. 1-yr treasury as the risk-free rate is standard for Black-Scholes. I’m sure Citi can go to another bank or insurance company for those options but not so easy for an individual investor, although the CME SP futures are close.

          I don’t trade futures/options although they’re accessible through Interactive Brokers. I have my main account there and pay $0.7/contract for equity options with no additional fees.

          Usually I’m a premium seller around my DGI portfolio. Going out 3-6 wks with 0.5-2% premium. I use technicals for stock selection and price points and aim to have the option expire worthless. I’m very selective about entry and only target several % annual from the option trades. I have dabbled in synthetic equity with leaps, with split strikes and custom ratios, always as a credit trade.

          Back to your structured note, I think it’s reasonable given the bank is not walking away with outrageous fees. Though my own macro view is that we will be higher in 3 yrs but will have turned down from the peak in 5. Hence the need for optionality.


          1. Hi NoRegret and Sam

            Wouldn’t going long leaps be superior to the structured note? With the leap you’ll miss out on divs as well, but at least you dont pay the 0.5% fee, you gain all upside, plus you dont need to put up the entire amount to gain the exposure, depending on your strike…

  37. Keep Calm and Invest

    What’s the credit risk?

    What if the market is flat, since you get no dividends, do you just very your money back?

    You say the market is at a top, but you don’t need to stick to just US stocks. There’s international and EM stocks to consider, which are nowhere near a top.

    1. You’ll have to make a bet that Citibank doesn’t go under in the next 5 years.

      I’m thinking it won’t if it didn’t go under during the last financial crisis and its much better capitalized now.

      Do you think Citibank will go under? What probability would you assign?

      Would you like me to write articles about the emerging markets and particular investments? Emerging markets is actually my direct investment experience.

      I’d love to hear ideas from you on specific EM stocks or countries. I’m pretty diversified in EM as well, but I thought I’d start this series with the S&P 500. Do you work in the investment industry or did you in the past?

      1. Keep Calm and Invest

        I doubt the banks have fixed all the issues…There’s always the fact that some employees are incentivized to take extreme risks with the banks capital.

        So I wouldn’t say the risk of Citibank going bankrupt is negligible. It may be small, but the risk is present.

        I also don’t believe that a major bank can stay in business by offering me a can’t-lose investment!

        Didn’t Warren Buffett sell long term puts on the index after it had crashed, being it would go up? That seems like a much better idea to me.

        My EM stock index fund has done well this year, up 12%. My EM bond fund is up 19%. Even my deep value US fund is up 18.5% YTD. So even if the market is overvalued, there are always pockets of value somewhere.

        I’d love to hear your thoughts on EM investing. If you have experience in this, why would you consider a concentrated bet with 70% of your portfolio in this structured note?

        1. What are these “can’t lose investments” the banks offer that you speak of? Every investment has risks except for the FDIC insured money market and CDS at $250k/$500k.

          I’m pretty sure Citibank has a higher chance of surviving the next market crash than your wealth management firm. Do you not agree?

          Where does it say that I am considering 70% of my portfolio in this investment? I’m starting to wonder whether I need to write much shorter posts and much more clearly with repetition or whether you and I just are not on the same wavelength?

          $200,000 is about 70% of my liquid cash. But my liquid cash represents less than 5% of my investable assets. I think I need to write percentages b/c people might automatically assume X amount of $ is a greater percentage of a portfolio for some reason. How big is your investment portfolio?

          Could you provide some background about yourself so I have a better idea of where you are coming from? I’m much more conservative than the average investor at this stage in the market b/c of my #1 goal of preserving capital while trying to return 2-3X the risk-free rate of return.


          1. Sorry, I misread/mis-remembered the percentages and maybe some of the facts. I tried going back to look, but I was reading on my phone, so that made it difficult.

            Are you including your real estate investments in your investible assets? Regardless, that’s very impressive.

            If it’s only 5%, then default isn’t as big a risk.

            I used to be an engineer, made some money in the last real estate boom buying 18 investment properties. Used it to go to b-school and travel for a year. Started my own RIA.

            I’m accredited, but my stock portfolio’s only $300k. Had to liquidate most of my holdings to buy a house 2 years ago.

  38. Sam, I dig the post and feel you’ve nailed the explanation. I don’t have much experience with structured notes and understood everything perfectly. Nice work.

    For Mrs. Geppy and I, right now, we (and by we I really mean me since she has no interest in investments) are mostly focused on maxing out my 401(k) at work that we just put in place in July. So I’m pretty aggressive there trying to max it out.

    Extra cash I had been putting into some biotech stocks. That sector has been in a bear market for awhile now but continues to grow revenue. I think it will be one of the only shining sectors should we see a correction.

    But for now we’re focused on bills (sadly). My companies healthcare isn’t amazing (it’s not terrible either), and it’s costing us about $13,600 in medical bills for our newborn, baby Geppy. He came early and spent 32 days in the NICU, so we hit our max out of pocket.

    We also have property taxes coming up and a roof assessment from our lovely HOA, so another $15,000 we need to get liquid there.

    Good thing I’m getting that 66% raise next month and Mrs. Geppy has a side hustle that pulls in about $500-$700 a month (her own blog).

    We also have about $40k in cash that I want to put into a 60/40 bond/equity portfolio via Betterment (love them btw, using them for the company 401k). That’d be our “emergency fund” which I know you’re not a fan of, but we’d likely never touch it and keep it invested in the portfolio. That said, I’m nervous about the markets too and would prefer waiting for a correction before throwing it into Betterment. Keeping it in a 1% APY Ally savings account seems like a decent move for now.

    But if we had more cash on hand I’d look at the structured notes. Sounds interesting… maybe in a couple years :-)

      1. Nope. We’re venture backed (even though we’re small), and doing the whole 100-150%/year growth right now and the foreseeable future. So most revenue is dumped back into growth.

        And being venture backed, it’s not just my interests as majority owner that I can think of (obviously). We’ve got a pretty vanilla 4% company match though.

          1. I’m a bit older for the startup world (34 now) so I like being able to offer benefits like 401(k) to attract talent when we are looking to add. My hope is that it speaks to an “older” demographic that realizes the value there. I just think they’re a better fit for our company and more committed.

            Yes, I’ve read that post. My goal isn’t necessarily to make everyone rich, but I do want to get as close as possible. Our company is small, and those that have joined have taken a big gamble on the company, and especially myself. I believe that deserves all the reward I can give it. So I like to top up equity when possible, control dilution as much as possible, and run the company in a responsible manner.

            I’m also of the belief there’s a lot of waste in Silicon Valley startups in terms of too many jobs for too little work. In other words, do more with less. Companies get too bloated in my opinion. And the fewer employees you have, the more equity you can share. That means a better outcome for all.

  39. Excellent analysis! This topic is not discussed much in the world of personal finance.

    This looks like a really good note, considering there is no cap and 150% participation. Quick questions..1. Have you done any analysis to see if you can replicate this yourself at lower cost and potentially higher upside/lower downside? 2. What is the liquidity if you have to sell this before “maturity”? 3. Tax impact..Do you buy in a tax-advantaged account?

    Overall, it is a very compelling proposition. Curious..who is offering this structured note?

    From the comments it is clear that it is relatively unknown/unpopular amongst majority of readers. Certainly makes sense for a portion of non-liquid cash.

    1. The cost is 0.5% of your investment, so this is something I’m willing to pay to not have to recreate the note. I’ve seen other notes that have 1%-2% costs/fees.

      I actually am going to buy the note in my rollover IRA so there are no tax implications.

      The secondary market for such notes is very thin. But I did sell a previous note very easily for a 35% profit. I have no plans not to hold this note until maturity unless the market moves so high that it gets to the point of ridiculous valuations.

      What are you investing in currently? Any good ideas and analysis you’d like to share?

      1. Good find. That is very low cost indeed! This is certainly worth going for. There are slim pickings right now.. I have raised some cash in the last few months, still looking for good opportunities.

        Have you considered or written about “equity indexed universal life insurance”?
        PS: I am not an agent. I work in SF Bay Area/Software. I did some due-diligence few years ago and decided to buy one. Structured product, with a life insurance wrapper. Higher fees, life-long commitment, higher risk, but does have some tax advantages.

        1. I’ve done some research on them, but I have never invested in one so I can’t write about it. Things start to get more complicated with the insurance and structured turns around insurance policies. Generally like to buy CDs for risk-free investing and and just insurance for insurance.

          When you start crossing the purpose of one investment with the performance of another investment, things get complicated and the fees generally start getting expensive.

          This note in this post is simply a plain vanilla S&P 500 structure note linked directly to the performance of this index. All I’m looking for his exposure with some downside protection over the next five years. Over the next five years there should be other downside protection S&p 500 notes as well. It will be like dollar cost averaging into these notes with production.

  40. Very interesting. A few years back, some bank reps roped me into a sales pitch for Market-linked CDs which seem similar to the structured investments you’re writing about. I’m more a plain vanilla investor…buy and hold low cost index funds. And when I checked out forums on Bogleheads and Fatwallet which was my go-to place for financial advice at the time =)…the comments weren’t too positive. I think they mentioned the limited upside, possible phantom tax, no dividends It was a little too complex for my simple mind so I passed. I think the participation rate was 75% and there was an interest cap. I’m sure these have different terms than the investment you’re writing about…I’ll have to re-read your post and see what my bank offers. What is the bank’s incentive to provide a 150% participation rate uncapped yet protect the investor from the downside risk. Once again, I’ll have to re-read your post when I get the chance as this sounds a little complicated…which is why I probably passed the first time around. But given your credibility, I will research this investment more!

    1. This is an UNCAPPED upside participation note. So if the S&P 500 is up 1,000%, you are actually up 1,500% in 5 years. Not gonna happen, but you get the idea. Lots of notes have capped upside, like 120% upside participation up to 30% etc.

      I would say MOST mass media publications, Boglehead, Fatwallet investors invest in public equity ETFs. Therefore, there is a natural inclination to look down on anything else. It takes effort to learn about new investments. What is unknown is generally feared or loathed. It’s totally normal.

      I’m just giving the FS community some things to think about beyond just naked long stocks and bonds. There are a lot of people I’ve talked to who’ve had MASSIVE cash balances as a percentage of their investable assets simply b/c they are too afraid to invest. I’m always fearful of losing money as well, hence why I look for such downside protection products.

      Check out: How Do The Rich Invest?

      What are some of the investments you are making with markets at all-time highs? thx

      1. Sorry for my ignorance but is the only difference from the market-linked CDs and the structured notes that you mention is that there is no upside cap. Right after I read your post, I saw this article on the WSJ mentioning the HSBC market linked CD which was the one marketed to me and it paints in in a negative light:
        “One series of CDs from HSBC Holdings PLC is called “Industry Titans” because the instruments are pegged to brand-name stocks. The 10 stocks underpinning a 2012 version of the CD, including Tiffany & Co. and ConAgra Foods Inc., were up by 46%, on average, at the end of July, according to FactSet. But a 6% cap on positive returns and a 30% floor on negative ones reduced the CD’s adjusted performance, which determines the amount paid to the investor, to negative 1.1%. The CD paid a zero return in July, for the fourth year in a row, according to HSBC.”
        I’m glad that I didn’t invest in the market linked CD in that case. How different would the result be if there wasn’t a 6% cap?

        I haven’t changed my investment strategy with the markets at all time highs since I’m a “Boglehead”…I just stay the course. But I still have been more worried about the market and have been hoarding some cash…part of that reason though is because I’m thinking I might buy a house in the near future. Not sure about the housing market either though.

        1. Besides the uncapped upside, but note that I’m writing about is just linked to the underlying S&P 500 index. It is for people who want equity exposure that has equity linked terms.

          The structured CD you are writing about is a risk free asset that is tied to risk assets in the article also talks about a lot of capped, asymmetric risk return variables.

  41. How do you assign a value to the lost dividend income (~2%/yr.) when comparing structured notes to other investments? Especially in a low-interest rate environment.

    1. Sure. Check it out.

      Financial Analysis

      When I first saw this note I wanted to immediately invest $200,000, or ~70% of my liquidity. 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.

      In the bear scenario, 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.

      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 after Hillary wins where the market actually goes down. There could be another international debt crisis that brings the world to its knees. Who knows for sure.

      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.

      1. It seems to me that the “fee” of benchmarking against an index but not participating in dividends at the very least cancels out against the upside participation rate. For example, over the last 5 years the dividends paid on the S&P 500 accounted for an approximate 20% return which means that in order to equal that on the upside you would need to have the S&P up 40% (granted this assumes reinvesting during a bull market). This is also true in the way down, yes you are protected up to 30% but you are “paying” 20% in missed dividends plus the true 5% fee. Based on this admittedly fuzzy math, you win when the index is up over 40% and when down between 25 and 30% and the bank lose the rest of the time. Also note that there are pretty extreme losses starting when the index is down 31%, then you would be down the real full 31% of the market plus the missed dividend opportunity.

        I know there are other upsides to this but other downsides not noted are that this is extremely illiquid and although it is sold as being diversified because it is based off an index, it is really an IOU from a single institution with no underlying equity backing it up and you could be out 100% if they default.

        Currently, after maxing out 401k and employer offered ESPP, I am saving cash (I own a couple of condos and am waiting on a good opportunity to buy another, preferably all cash) and dollar cost averaging low cost Vanguard indices focusing on dividend stocks.

        1. Sounds good. Citigroup could go bankrupt/default in 5 years, there are no guarantees. What percentage chance do you think this will happen?

          Are your investments 100% naked long in public equities? Or do you have hedged investments and private investments for diversification? thx

          1. Will just put this here as some interesting thoughts.

            Bloomberg was actually talking about this today.
            Banks shuffling business structures to deal with structured notes:

            I post that because your counter party may not be Citigroup Corp inc it may be Citigroup NA or a shell holding company.

            As to what is the risk of the parent not being there in the end. The best way to quantify it is looking at their credit rating (its not perfect but it is the easiest available metric)

            Citigroup inc long term ratings are Moody’s – “Baa1” S&P – “A” Fitch -“A” all stable.

            if you look at historic corporate defaults from those ratings you get between 2.69-4.64%. So you can use that in your risk.

            I am more familiar with doing this analysis with bonds and not notes which generally have some underlying recovery due to asset backing even in event of default. I am sure with banking assets there will be some recovery there but I don’t know what the %age would be.

            I do look at structured notes. I have owned one in the past, I currently own none right now because none seem to have had the right terms for me. I currently hold bonds (individual issue corp/Muni) and index stock funds.


          2. For the equity component of my portfolio, which makes up approximately 25% of the total, I’m 100% invested in VTI. I’ve always been in a total market index since I started investing in 2006 and pretty much never sold (in fact, I’ve only bought more) every year since. Diversification is across asset classes: long-term Treasury bonds, gold ETFs, cash, and real estate.

          3. I’m long, naked. My wife and I are in our early thirties and have spent most of our careers investing in 401k and real estate so I do not have so much principal in my after tax investments to justify hedging. My “hedge” is that i am very long in cash and would continue to dollar cost average through a falling market and look for buying opportunities then. Agreed that citi going bankrupt is not a huge concern, just wanted to point out that this investment isn’t as diversified as it seems being based off an index.

        2. I agree with Eric’s concern of losing out on the dividends of just being naked long the S&P. Once you count the fees and lost dividends it seems like this isn’t the greatest investment vehicle

  42. Here’s a good site to see what Citi is currently offering and to gain more knowledge of these investments. I’ve personally invested in several structured notes and really like having the downside protection. Unless I’ve missed it though, I’ve yet to find one with 150% uncapped, upside participation Sam! The current S&P500 Barrier note has a fixed return amount of 22-24% and a 20% barrier.

    1. Interesting link. Where am I looking to find the various notes?

      The note in this post offering closed at 12noon PST on 9/7/2016. What I did was use the proceeds of a note I bought in 2012 that had a 20% buffer w/ 100% participation, sold it, and rolled the proceeds over to this note with the 30% barrier and 150% upside participation. My original note w/ 20% buffer is so far in the money that it’s never going to be used any more.

      This is the best S&P 500 structured note I’ve seen in the past 4 years of looking. BUT, it has to be the most attractive b/c the S&P 500 is at an all-time high. Nobody would bother to participate if the barrier wasn’t 30% and the upside participation wasn’t at least 125% for these terms.

      What are some investments you are investing in currently and why? Thx!

      1. Sorry, select North America and then Private Investor. Accept the terms and then it will take you to the site with their current note offerings and education materials on all the notes they offer.

        1. Ah, very cool! Look at that, a world of different structured notes to research and choose from in one place. Notice how a lot of the plain vanilla index notes have capped upsides of 24% – 30% or fixed upsides with only 110% – 120% participation rates.

          This is why the one I highlight in this article seems so intriguing with uncapped upside and 150% participation rate.

          Not sure why this note isn’t in the September brochure. Maybe it was in the August brochure as it closed on 9/7. I just have my banker comb through all notes for me based on my set criteria of risk and income and send them over once a month.

  43. All this talk about “top of the market” suggests we are going down from here. It plays into investor psychology and why most investors are their own worst enemy. Slight adjustments to a portfolio are okay but be careful about making big changes. Bare in mind that even those slight adjustments to a portfolio may be a bad move. High fees and lack of dividend is why I will stay away from structured notes but I’ve enjoyed your analysis of the product. It may be a good option for someone who is less aggressive than I am. And it is certainly a better option for most than an annuity.

    1. Just stating the fact that we are at the top of the market since we are at the top of the market. The market can go higher or lower from here, nobody knows.

      If it wasn’t for hedged investments that have downside protection, I would not have been as aggressive in investing in equities as an unemployed guy trying to build a business. But I decided to invest $225,000 in 2012 in these notes, and six figures every year since until recently b/c they helped overcome my fear of losing money.

      I’m throwing options out there as I know a lot of people don’t invest b/c they also fear losing money logically. But for those folks who haven’t invested over the past 7 years, they missed out on a lot of returns.

      And here we are. Things look toppy now. What to do?

      I’d love to know what you are investing in and how your net worth is structured.


      1. Yes it is true that it is better that people invest rather than sit on the sidelines and if structured notes helps them to do that, then great. I keep about $150k in cash, and my investments are about 60/40 Stocks/Real Estate. I don’t own much in the way of bonds and have a primary home and 1 rental property (duplex). I put my extra cash flow into stocks on a regular basis with a tilt towards good values. So yes, aggressive and not for the faint of heart but it has allowed me to grow my wealth nicely over time.

  44. Fiscally Free

    Thank you for sharing this type of investment information. I had no idea these types of investments existed until I recently read your older post on structured notes.
    We plan to sell our house at the end of the year and I have been stressing out about where to put the proceeds. A structured note like this seems like a great option when the market is so high.

  45. Thanks, Sam. You’re posts always make me think, and I feel like I come away smarter for having read them.

    I’m somewhat surprised to read that you favor using cash to pay off low interest debt, “even if the money could have made more money in an investment.” Is that because the incremental gains are less valuable than the peace of mind that being debt free offers? Is it because the payoff is immediate? Something else?

    I’m interested because I’m currently sitting on about $10k cash, and I’ll very soon have another ~$10k cash (w/in the next 60 days). I have some debt, but it’s all very low interest ($7k @ ~1.5% and $20k @ ~4.5%). Long term I’d be better off investing in index funds. But with the relatively small numbers I’m dealing with, maybe the incremental gains aren’t worth me sweating over in relation to the immediate benefit I’d get from paying off the debt?

  46. In those amounts ($100k+), would you not be able to replicate the risk/return profile closely with calls/puts?

    Could be that the index optinos are much more expensive than individual stocks (I believe they are at six figure amounts, but not sure myself), so this could be a reasonable in-between for a retail investor without millions available to invest.

    Personally, I’d love a way to hedge slightly, though I prefer to be long and simply use asset class allocation to meet my desired return. That view may change if I ever start investing in chunks at $100k+!

    Has not happened yet, but the shift from actively growing wealth to sacrificing some gains in order to preserve capital is an important one. Why gamble once you’ve already won?

    1. I’d rather pay a half percent fee and have everything done for me and wake up in 5 years and see how things went. But that’s just me. In my younger days when I wanted to spend more time investing and trading and analyzing I would be more inclined, just like I’d be more inclined to buy and sell cars on Craigslist. I did so 8 times! Nowadays, no way. I’d rather do something else.

      What stage are you in your investing journey? Not losing principal is rule #1 once you’ve accumulated enough money to live off. Rule #2 is to never forget rule #1!

      1. I used to be far too aggressive in some of my yield and allocations. Specifically, I went a bit out of whack in energy partnerships and closed end funds earlier in my investing experience.

        I’m just shy of 5 years in work (hard to read that out loud in my head!), and began divesting the riskier/non-core assets in year 3. I hold a few very small/limited positions in some index based CEFs now (e.g. DIAX, QQQX), but the rest of the specialized ones are done.

        Today, I mostly invest with the goal of achieving a risk/return profile that makes sense. While 8%+ returns may be nice, 5% average returns over 15 years will go a long way. I now invest majority into broad indexes (US/Intl stock, US bond) through 401k, which is a bit over half of my new capital, and the rest into a trading account with mid/large cap stocks.

        The larger the personal account grows, the more I see returns gravitating toward the major indices. I tend to think more about overall risk/return now than gaming for maximum gains. To your point, the risk/reward is not met in certain areas.

        I can totally see the appeal of the structured note you detailed above. With the exception of issuer credit risk (much lower now than before the bank issues), it makes a lot of sense to aim for the middle ground, with some built in hedge.

        Hoping to accumulate $400-500k by 30, still a few years to go, and then take another step back in my overall investment risk. More bonds and real assets.

        I’d rather put my focus on growing my career and maybe eventually some other business interests than swinging for the fence in my portfolio.

        Did you see much of a change in your investing style as you passed 5, 10, 15 years of work/investing?Seems you’re much more comfortable with a higher allocation to real assets now, but managing property sure isn’t as passive as it seems!

  47. My question is what is the liquidity on this and how deep does it go? If the stock market goes south hard, who’s your buyer on this? My guess is that you’d get crushed if you needed to sell it, in which case I’d ask why not just go long on the stock market bc at least you’ll have a bid.

    This might not be the same thing, but a friend of mine ran a hedge fund and was selling what I think was structured notes to investors to get money to invest. My thoughts are that if he failed at investing, you might not have such a safe principal to draw from

    1. It’s not very liquid, which is why investors should be prepared to lock up their money for 5 years, just like someone who buys a 5-year CD, venture equity fund, venture debt fund, etc.

      So long as Citibank, the offering institution doesn’t go out of business, you’ll get the terms of the note after 5 years.

      One of the very telling differences I’ve observed for those with a larger financial nut is how much more long term they invest. There are really no thoughts of needing to withdraw money early because they are so diversified and have such large cash flow. The longer you can lock up your money, generally the better the terms.

      What are some of the investments you are making currently and why? I’m always looking for ideas. thx

      1. When I bought a house last year, I needed to raise cash so I sold 2 structured notes for a profit and prior to maturity through my broker at Citi Private Wealth Mgmt. Only had them for about 18 months. One of them was a Citi-developed note and one was from another bank. Sold them same day I made the decision to sell. So there is a market for them, it’s just not through an exchange. It’s among banks/brokers. You can see that they have 3rd party offerings at the site I posted previously.

  48. Sam,

    Very thought provoking read. Honestly, I have not looked int these extensively. I did however come across a recent review (summer 2015) by Larry Swedroe on structured notes.

    The review by Swedroe is pretty damning to be honest and the fees discussion and section on principal protected absolute return barrier note (ARBN) are worrisome. The table in the article on mean returns is also grim reading.

    Don’t get me wrong, I have more to read. But not in a real hurry to do so.

    1. I expect a website that has ETF to be damning of every investment or asset class that has a higher fee that an ETF. We definitely fear and loathe what we don’t understand or don’t invest in. We also always believe our way of investing is the best.

      I hope these type of articles help give the FS community knowledge as well as new investment ideas.

      What are some investments you are making currently and why? I’m always looking to learn and research new ideas. Thx

  49. Your counter party is WHO, other than issuing bank ? (Hopefully – not Lehman brothers !?)
    Can you sell this in open market ?
    What if you want to cash-in when market is approximately 28% down anytime prior to 5-year term?
    Do we know the bank which issued that note – is it solvent, or run-on-the-bank?
    Are these protected/regulated by FINRA/SEC/FDIC ?
    Are these notes traded on any exchange to help transparency ? (guessing NOT)
    If market goes down more than 30% ., would the value goes down gradually from that point – or All-the-Note’s value becomes KAPUT ?
    Any healthy discussions regarding Structured-Notes on net/bogles ?

    I think one should make a “personal” gut feeling that market may never go down more than 30% during your “term” of holding that Note – else all the principal (and the growth?) could become ZERO ?


    1. Great questions. What are some investments you are making currently and why? I’m always looking to learn and research new ideas.

      * Citibank
      * Yes, but thin secondary market so spreads are higher
      * Yes, regulated, no FDIC insurance like most investments
      * Don’t understand what KAPUT means in this context

      1. As much as you (and many others) would like to keep it simple — I don’t talk about individual investments — just say that: I am doing above-par with my bag of indexes, 3x’ers (limited portion), basket of stocks & limited bonds-index; continue to invest in market via 401K/IRAs. Doing 3% over S&P index over last 15 years in a row (except in 2015, only did on par with the S&P). Definitely keeping ‘some’ cash buffer – waiting for good opportunities and/or dips.

        Citibank – ain’t so bad; just came too close to sub $5 stock price for extended time (infact, it still is, technically, if not for reverse split trick :-)
        Regulated – but not much oversight/enforcement – not enough people, processes, or govt auditors sitting at their derivatives trading desks :-)
        My mistake on saying KAPUT. Thought that – if the principal on maturity goes below 30% value – All the principal-value would become ZERO; but upon further reading, and clarification among various comments – it became clear that – upon maturity if the note’s value falls below 30% – the note assumes index % ..

        If we don’t have investing ideas – do we have invest in ‘something/structured-notes’ asap ? The best gamers are the ones who don’t rush to play, or better yet never take-a-gamble at all – when the time appears to be not in our favor :-)

        As far as the sentiment that: Market being over-valued — may be, may-be-not !? Stay on course – we’ll all be fine over longer term!

        Just have patience folks (continue to invest – while keeping some cash/liquid buffers) !!


  50. just a thought

    Very interesting article.

    On a side note, while the markets as a whole are at all time highs, there are always sectors, and companies that are undervalued. Why not explore those and use calls/puts to manage your risk and generate a few bucks of income?

    1. Definitely a good point. Which sectors and companies do you think are undervalued now? I’ll do some research on what you recommend as I always like doing investment analysis. Thx.

      1. just a thought

        Oil and all things oil related, as an example. Certain mining and manufacturing areas.

        I also peruse the daily losers (in terms of $ and %) and see if there are trends/hiccups that are starting to occur across sectors as well as find companies that are being over punished.

        This is not intended to be viewed as a speculative trading strategy, but learning how to identify a good value when you see it and then act on it.

        While companies like IBM, WMT, CAT, etc are rather boring, if you know what you are looking at you can get in at decent times, which certainly protects your downside.

        1. just a thought

          EDIT: I am not saying CAT, IBM, WMT are undervalued right now, but they sure have been in the recent past :)

          1. Man, Warren Buffet got ROCKED investing in IBM since $200.

            You’ve highlighted some of the largest cap names traded today. What is your “edge” in these names and why do you think they present good value?

            1. just a thought

              While he got rocked at IBM, others seeing IBM at recent lows of 120ish, didn’t. I remember when big blue was in the around 200 and many of us thought it to be comical.

              I look at things like longevity, having moat around their business (who else is gonna replace CAT, WMT really?) I recall WMT dipping when they mentioned they would close under performing stores and then shortly there after the stock bounced and has had appropriate gains since.

              Obviously in these cases we aren’t talking multi-baggers, but lets be honest getting solid blue chips at double digit discounts is not a bad way to add some equity and stability to the portfolio.

        2. My experience looking for undervalued stocks has been the opposite of a structured note–those prices swing all over the damn place (up and down)! It’s funny you mention IBM, because I actually bought it believing in the strategic imperatives turn-around story and was down a good 15% before I was up 15%… Better risk/return in this structured note I think.

          I enjoy playing around looking for unicorns and undervalued stocks, but only a small portion of my net worth ~10-20%.

          The principal protection and 150% participation seems unreal. I think the money spent of put/call fees would be better spent on this structured note.

          If I were in Sam’s place, I would take the note!

    2. The Long Haul Investor

      Buffet could probably care less that he’s been getting rocked in IBM. He actually was a buyer of the stock earlier this year. He’s thinking at least 5-10 years out still. I own it too I should add. Back when the stock was under $140 was the best time to buy. For investors the key to buying and undervalued company is

      1. determining it actually is undervalued
      2. determine what price is the max you’d pay and buy whenever it’s under that level
      3. have a decent understanding of basic technical analysis to backup your “buy below” price. This last step helps minimize your risk.

  51. Great in-depth analysis! Sounds like a good opportunity to me. I’ve invested in several different structured notes over the last several years. Most of them are tied to one or two indexes. I’ve invested in a couple that were tied to single name stocks, but have since stopped investing in single names because they’re riskier than my current appetite. The fees sound reasonable on this one and that’s something I’ll pay more attention to in the future.

  52. Stefan - The Millennial Budget

    Interesting concept and an investment vehicle I never really thought of. I will need to read it over another time to fully grasp the concept but this is far too much principal required for a young guy like me. I am better off putting that cash into buying a rental property or something for the long term future. What is the appropriate age you believe somebody should use this investment method? I understand the whole hedging concept but shouldn’t people my age (23) be taking on some more risk.

    1. The interesting thing with this investment is that it provides an UNCAPPED 150% participation rate. Usually, I just see 100 – 120% participation rates that also may have some caps (up to a 32% return etc), so this one is more intriguing.

      It feels to me this investment provides more upside than going naked long while also having the 30% downside barrier to not lose money after 5 years. We’ve all been stuck in this “always goes up mentality” for the past 7 years where people have forgot markets do go down sometimes.

      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 don’t need 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 have a long-term outlook and don’t mind locking up money for five years.

      * You have cash sitting in your IRA that can’t be touched until 59.5.

      1. Hey Sam, could you say more about how these structured notes are funded? You mentioned above “You have cash sitting in your IRA that can’t be touched until 59.5” – can you fund these investments using tax-deferred or tax-exempt IRAs, 401ks, or Roths?

        1. I have a rollover IRA w/ the bank and the bank offers these notes. So not only can I invest in this 5 year note w/ my rollover IRA I can’t touch for 20 years, I can invest in the notes w/ my private wealth management account as well.

          What are some investments you are making right now in this market and why? Thx!

  53. There are strategies like options too. Doing a collar strategy on sp500 (insiders with large restricted stock holdings do collar trades)

    Sell calls above the market and buy long term puts to protect downside….

  54. I’m just holding cash for now because I don’t know where to invest. I asked about structured note at my CU and they have no idea what I was talking about. I probably need to open an account at a bigger bank. I dislike investing with bank, though. I feel they have a big incentive to be a salesman. Not good for beginner investors.

    1. Your feedback is why there is a lot of opportunity and arbitrage in the private market. Most retail investors simply aren’t aware or don’t understand the other investment opportunities out there. There were a lot of hedged investments purchased in 2007-2008 that saved people a lot of money or made people a lot of money when the markets rolled over by 50% from peak to trough. Meanwhile, most people were naked long and got slaughtered if they sold during this time period. The fear was immense.

      I truly hope the bull market continues for another 5 years. A 12 year bull market will make many of us much, much wealthier. But nobody really knows the future, which is why hedging your bets with upside participation isn’t a bad idea.

      You should forward your bankers this post. They might be interested.

  55. I’m generally against structured notes because the bank is just wrapping traded derivatives into a package and selling them at substantial markup.

    To be fair, retail investors are unlikely to be able to access these instruments, but that doesn’t change the fact that most notes pay the salesperson a >3% commission upfront and the bank is making additional money on top of that.

    Notes may also be taxed as income (instead of capgain) depending on what country you are in, and there are questions about liquidity before maturity since the bank can set whatever bid/ask they want.

    Some or all of these drawbacks might not apply to the specific note you are buying, but the questions should be asked.

    1. Yikes, is that how much banks charge in Canada? That’s a lot. But even if it is 3%+, it’s a good exercise to first approach the investment opportunity with whether or not you like the terms, since the terms are almost always stated NET of fees like this instrument I’ve written about. Then you can look into the details to see how much the actual fees are.

      With this investment, the 30% barrier and 150% upside participation is net of fees. And the fee is a half a percent e.g. Invest $1,000, you pay $5. In my mind, the fee is low and the conditions are ripe to allow me to take equity exposure risk at the top of the market.

      What are some alternative ideas you have at the top of the market? And what are you doing with your money?


      1. I think viewing the fee as a static 1/2% is potentially misleading. As Ryan points out, you may not have considered that the core components of the note have a fair market value and these are embedded in the note at a premium to the market value. In actual fact the bank may make a fee of 1/2% plus gain on any of this more “opaque margin”. Banks are however providing a service in that retail investors may not have access or knowledge to package the note themselves (with the requisite underlying derivative components, dynamic hedging, valuation and inter-bank access). If the payoffs appeal to you and the price seems reasonable from a risk / reward perspective, this demonstrates a potential win-win scenario for the investor and the bank.

      2. I read about a potential alternative to this (to be used in a registered account only). The suggestion was to purchase a strip bond and invest the difference between the face value and the purchase price in a vanilla ETF of your choice. Your principal would be guaranteed at the time of maturity plus you’d receive dividends and any market return on the etf portion.

  56. Simple Money Man (SMM)

    Hi Sam,

    This sounds interesting and complex. TBH, I’m not sure how structured notes really work and am of the Warren Buffet mindset for now – invest in what you understand, :-). So, I’ll read up more about it to see if should include it in my building portfolio in the future especially due to the ~8.3% return you mentioned!

    1. Bummer. I thought I explained how this investment idea worked with the chart and writing in my article. Perhaps go over it again?

      If you still don’t get it, is there anything specifically I can help you explain?

      1. Simple Money Man (SMM)

        Trust me, you did a great job. It’s not you, it’s me, lol. Seriously though, I just need to read it over again and take notes to learn about this investment vehicle and how they differ from let’s say bonds.

  57. Hey Sam,

    This is a nice article; at the very least, you’ve given me an excellent description of a principal protected note.

    The question hanging over my head that probably answers Dividends Down Under’s question is: what are the fees on this S&P product? Probably rather high. But I suppose you should pay a lot for principal protection in a leveraged security!

  58. Sounds interesting but got to check if such an instrument is available in my market – India.

    As to what I’m investing in during times like these when markets are at all time highs or close to it, our fixed income market gives 8-10% in any case so it’s a no brainer. Will accumulate in short term funds until the market coold down a bit. There are also some nice gold bonds that also pay extra interest of 2.75pa (over gold price changes).

  59. So what are the fees with a structured note like this? No such thing as a free lunch, so where does the bank make their money? Also, you don’t own any of the shares at the maturity correct? And how much does losing the dividends affect your return?

    1. It’s half a percent. So if you invest $1,000, the bank gets $5.

      The terms of the deal are net of fees too. I like to analyze the deal net of fees as they are usually presented. If I like it, then I’ll look at what the fees actually are. It’s more logical than looking at the fees first, and then the deal. What if the fee is 10%, but the deal is 100% principal protected and guarantees a 20% annual payout for 5 years?

      What are you investing in at the current moment?

  60. @Tristan: The provider makes money by keeping 5 years of dividends, as well as the coupons they would have had to pay to issue a 5y CD, less the cost of a ladder of put/calls to hedge roughly the shape of the payoff.

    Personally, not something I would buy, because of how hard it is to analyse the price of the package vs its constituents and see if I’m getting a good deal. A CD + a call would give most of the payoff with more transparency ?

    1. You could not replicate this with a CD and a call, but you could with an unsecured note from the issuer and a package of options.

      The provider is not “keeping” any dividends, it’s just a call option they source in the market and then package into the note, and calls don’t get any dividends (though the option pricing models account for this, at least in theory)

  61. I have googled this topic many times in search of more insight on what to invest in at the top of the market. Thus far the only tactics I have followed is to deleverage and save up cash for future rental properties.

  62. This is an interesting analysis. I have read before that approximately 60% of the stock market’s historical gains have been through appreciation and the rest through dividends (believe that was a Benjamin Graham quote?). If that is true, I would look at this type of investment as basically a derivative type hedge. The cost would be 10% of your EV (60% * 1.5 = 90% of total return), but the payout would be 100% of losses up to 30%. This seems kind of similar to a covered call the way I’m looking at it where you reduce both up and down-side, with a twist.

    I’ve been following your blog for some time, and you appear to be in the low interest rate for the long haul camp. That would probably skew your analysis of market return towards appreciation and less on yield. Re-running the math with lower % of total returns from dividends would yield better upside and lower downside than your base index. Overall, super interesting investment! I always like coming here and seeing what new things you come up with. Keep up the awesome work Sam.

  63. It is a conundrum of what to do with the market peaking. For me, I like to keep things relatively simple and easy. I’ve got my tax-deferred accounts maxed-out and the remaining savings is going towards paying down the mortgage. It’s not much of a return, but it’s guaranteed. Having the house paid off will facilitate my FI goals.

    I’m thinking of starting a dividend growth portfolio as well, but as you said, with the market so high, I’m not sure it’s a great investment.

    I liked your discussion of structured notes. I’ve stayed away from derivatives to date for the most part, although I used to write some covered calls to make extra cash a few years ago. Right now, I don’t have time to look into anything too exotic!

    1. The funny thing is that a lot of retail investors thinks these notes are exotic b/c they don’t understand what it is. This note is about as plain vanilla as it gets, investing in the S&P 500 with an upside participation kicker and downside protection.

      These type of hedged investments is how many people who’ve accumulated their financial nut invest because their #1 goal is to not lose principal.

      I hope people are less afraid of such investment ideas as they learn more about them.

      1. MedSchool Financial

        Hey Sam, Interesting post shedding some additional light on these hedged notes. Much like Jon, currently working on being diligent to build the financial nut. I like the approach of critically analyzing potential investments for both your edification as well as FS readers. Thanks for sharing and curious to how much you decided to invest?

          1. This can be reconstructed via options in a much cheaper way. However, it may not be worth the hassle if it is a small portion of your portfolio. This is a great time for collars though, imo.

  64. This is very interesting Sam, and something that I’m sure we won’t be considering (or is an option for us) for a long time as we’re very vanilla investors at the moment.

    How are the providers of this making any money? Are they shorting and investing in the S & P 500 so that they will ‘win’ more than you either way?

    Either way, good luck with your investing Sam. As with everything you do I’m sure it will be a success.


    1. these products have up front fees like he mentioned. if you look at whole term though it’s less painful, 2% over say 5-7 years is .2-.4%/yr. that’s equivalent to some index etf’s that offer you no downside protection. or think about just having a naked long portfolio and outlaying cash on your own to buy puts to protect your downside.

      (i help financial advisors sell these)

  65. Thanks for writing such a detailed analysis on this investment option, Sam! Based on what I know about your personal risk tolerance, it sounds like you’re about to make a smart choice. Are structured notes available to purchase through any brokerage account?

    1. I don’t know whether they all do, but I do know places like Citibank, JP Morgan Chase, and other big banks or private wealth management firms do. Just got to ask.

      The #1 goal in investing, especially if you’ve accumulated a large enough financial nut, is to not lose principal. Going in reverse is no fun. With the markets at all-time highs, finding a hedge with an upside kicker is a good idea. But I’m happy to hear the contrary.

      1. The Long Haul Investor

        Off the top of my head I can think of Fidelity, Ameriprise, Merrill Lynch, and Vanguard all offer some type of structured note product. So it’s best to ask your current bank/broker/advisor if they are available to you. I know even some financial advisors will offer them to clients too.

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