Paul Winkler: Welcome. This is “The Investor Coaching Show” and I am Paul Winkler. As always, I am discussing the things that are probably on your mind because they’re out there being talked about in the media.
Good News and Bad News
The media loves to make you so at ease with everything that’s going on, and sometimes you just have to hear the other side of the story. There’s always another side of the story. One of my friends once said, “There’s three sides to every story. It’s your view, my view, and the truth, right?” It’s kind of how that works.
So one of the questions that came up this week was about structured notes. When you invest, you’ll have different market segments that you might invest in. You might be investing in big companies, you might be investing in small companies, you might be investing in value companies and growth companies in international and U.S. and different types of bonds.
Especially as you get closer to retirement, there’s always something to be scared about. There’s always something to be worried about.
Bad news sells way more and way better than good news.
As I often say, the reason is because with good news you don’t have anything to prepare for. There’s no risk, there’s no threat to you with good news. The threat is with the bad news, so therefore, I would gravitate to that because then I can do something to prepare to protect myself against it.
There’s nothing to protect yourself against when it comes to good news. So hence, the media overwhelmingly leans into bad news. I talked about that recently with our media here in America versus other countries around the world, and this was actually tested in research, how our media responded to the pandemic was way worse than other countries around the world.
Financial shows, a lot of them are more geared to sell things. I gear this toward education because we don’t sell anything. And I think that as an investor you’re not as liable to be sold something if you’re educated, you’re not liable to be put into something that you really don’t belong in.
Structured notes are one of those things that you might be tempted toward. Basically, with structured notes, you’ve got a financial institution issuing one, and they may base the returns on equity indexes.
A lot of times we hear the idea that indexing is a good thing. And again, indexing works really well compared to active management in large U.S. and large international stocks. It doesn’t work as well with small companies because it overweights bigger companies, so small companies have a higher expected return than big companies, and you’re overweighting the big companies, which doesn’t make any sense.
What happens with value companies is the same thing. When you’re dealing with value companies, by definition of value company would be a lower price thing. And when you’re buying a value index, you’re buying bigger companies. Again, that doesn’t make sense.
It actually, return-wise, historically is much, much greater loss of returns with indexes versus an asset class investing approach where you aren’t stock picking a market timing like you are in an index fund, but you’re not overweighting those big companies. Now with a structured note, they’re basing it on an index and your return will be based on the movement of that index.
Don’t neglect opportunity cost.
And what happens is they’ll have this fixed maturity and then what will happen is they’ll have a couple of components, a bond component and an embedded derivative. It is kind of like indexed annuities in a way where you buy bonds and they’ll say, “Hey, we’re going to guarantee you can’t lose money.”
They buy a bond at a discount and let it mature to full value. The other money, let’s say if you take $100,000 as an example and you buy $70,000 in bonds that will mature to eventually be worth $100,000, and then the rest of it you buy derivatives. So now, we have the potential to get a certain return.
You could end up with nothing but your money back. They make it sound really good. You can’t lose any of your money, but you have a lost opportunity cost of the return you should have gotten had they not sucked your return away from you is really what it gets down to.
Structured notes are described as securities issued by financial institutions whose returns are based on, among other things, equity indexes, a single equity security, a basket of equity securities, interest rates, commodities, foreign currencies. So they can base this thing on a lot of different things that you probably shouldn’t be investing in.
Thus, your return is linked to the performance of a reference asset or index. Structured notes have a fixed maturity, including those two components, the bond and the embedded derivative.
Now first of all, one of the things that you have that you don’t hear about in the sales presentations are market risks. And that’s what the SEC talks about here is that they can provide for the repayment of principal at maturity and you can have principal protection, but it’s subject to the credit risk of the issuing company.
With structured notes, you’re dependent upon the issuing company being solid themselves as a firm.
It doesn’t necessarily give you a warm fuzzy there when it gets down to the real protection. And it says the performance of the linked index or asset may cause you to lose some or all of your principal.
Liquidity risk is that you may not be able to sell these things back, you may not be able to get your money back. And I kiddingly call that the Hotel California effect. Check out anytime you like, but you can never leave.
In addition, issuers are specifically disclaiming their intentions. So the issuer says, “We’re going to disclaim our intention to repurchase this stuff.” So guess what? If you want to sell it, good luck. Good luck getting your money back.
Structured notes may be complicated payoff structures that can make it difficult for you to accurately assess their value. This is something we dealt with in 2008, isn’t it?
We didn’t know we had a market to market idea. We didn’t know what things were even worth. That’s what that whole term came from in 2008. Payoff structures can be leveraged, inverse, or inverse leverage.
But you think about it, the people out there that are looking at buying these things, how many people actually understand what they’re getting, let alone the investment people even understand it?
I wonder if the investment people would even be recommending this stuff if they really understood it themselves.
Well, they probably would because of the amount of payment, and there’s some people that’ll do anything for the payment or the commission that they get for selling something.
Participation rates are something you also see in indexed annuities as well. Again, we’re talking about structure notes here, but they’re alike in many ways to indexed annuities.
But wait, there’s more. If you actually look at the S&P 500, you have two components of the returns. You have the return of the asset going up in value, but you also have the dividend paid.
So what happens when a company pays a dividend, they may pay a dividend part of their earnings back to the end investor. And especially, when you’re dealing with the value components of the S&P, a lot of your return is going to be dividend. Then you have the appreciation, it goes up in value.
Well, if you look at 1970 through 2022, the return, if you remove the dividends from that equation, is about a quarter of the accumulation. So you look at that and go, “Wow, that’s a huge amount of the return just sucked away.” And that’s not even counting all the other bad stuff I talked about.
Call risk is an issue I always talk about with regards to bonds. If you have the ability to call your debt. Quite often you can do this as a consumer, in a way. Let’s say you have a mortgage and then all of a sudden interest rates go down. What are you going to do with your mortgage?
Well, you’re going to refinance it, right? It’s the idea. Refinance it, get a lower interest rate. Well, if you refinance it, that’s great. The bank kind of loses out because now they’re lending you the same amount of money but at a lower interest rate.
Well, now imagine yourself on the other side of that equation. You are the lender and the company that has borrowed money from you has the ability to actually call the loan. Now, when are they going to call the loan and refinance it? When interest rates go down.
Now what do we know about bond prices? When interest rates go down, bond prices go up. So just when you have the ability to make more money, they call the debt on you. And now you’re sitting there going, “Oh man, just when I was going to make money on this thing, they pulled the rug out from under me.” So that’s exactly what they do.
Again, it’s not me talking because I don’t have a dog in the fight. We don’t sell things to the public. My real goal is not to be an infomercial, although we do manage money and we do financial planning and all of those types of things.
My goal here is to be an educational show.
So when people listen, they go, “Man, this makes so much more sense than anything else I hear anyplace else.” I just want you to understand where my thinking is.
What happens with these structured notes is they go and call these things and all of a sudden the Securities Exchange says, “They redeem the note before it matures at a price that may be above or below or equal to the face value of the structured note. And then you may not be able to reinvest at the same rate of return provided by the structure note issued.”
Well, of course you wouldn’t. If interest rates go down or if returns go down, that’s basically what they’re doing. Part of the disadvantage of these is that they are complex and difficult to understand, as well as high fees and expenses.
Structured notes carry high fees, which ultimately hit the returns of investors. Fees even hurt the underlying, if the underlying does not perform well. In other words, the house makes money whether you win or lose, killing the returns further and maybe putting the returns into negative territory.
The risk involved in a structured note is much higher than any other asset classes, and the worst part is that the investor will not have an exit if the investment bet goes wrong.
I think that’s what you need to know as an investor because you can get pulled into something in a hurry, thinking you’re going to get something from nothing, that there’s a free lunch on the table.
The only free lunch on the table, typically, is where these people are out there doing workshops under the guise of, “We’ll teach you about social security, we’ll teach you about how to save on taxes, we’ll teach you how to save fees,” even though you end up with something that is much higher fee than you ever imagined, but that’s how they attract people to their workshops, and then bam.
They’ll pull you into some kind of workshop and then all of a sudden you get hit with something like this. And I know there’s all kinds of gimmicks like: “A ratchet only goes forward, it doesn’t go back. You can only make money. You can’t lose money,”
They just don’t tell you the whole story in my experience. And it’s a shame, but that is how people get pulled in. So education, education, education.
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