Simon Parker, COO at Holborn Assets, examines the pros and cons of Structured Notes…

There’s much uncertainty, and confusion, around the subject of Structured Notes. I know from experience that people often complain about them – their   high-risk derivative basis and level of uncertainty built in, which is why we chose not to offer Structured Notes at Holborn Assets. Nevertheless, plenty of organisations do – so what exactly are they and what is it important to understand about them?

How do Structured Notes work?

A Structured Note is a ‘derivative’ that is a financial arrangement based on a couple of underlying reference assets or benchmarks. It’s called a ‘Note’ because it’s essentially an ‘IOU’ note from the issuing bank to you the customer, agreeing that they will pay you a return directly proportional to the satisfaction of a set of given market-related criteria. You’ll be paid either in regular intervals during the course of the Note’s duration, or only when it comes to maturity and expires.

Structured Note Pros

  • On the face of it, Structured Notes offer the best of both worlds – allowing you (the buyer) to benefit when the markets move up and simultaneously be protected when the markets move down.
  • A Structured Note will usually give you an enhanced rate of return on any gain in the underlying reference asset/index.
  • They’re flexible – a note can be issued in virtually any market or combination of markets, so there’s plenty of choice.
  • They’re also tax-efficient – the return on a Structured Note is generally considered to be a long-term capital gain.

Structured Note Cons

  • They are so structurally complicated (being based on an underlying asset as wells as another derivative), that it is often difficult to see how they work, let alone spot any potential pitfalls.
  • If the bank fails but the markets remain, the assets/derivative/index underlying your Structured Note may give you a theoretical positive return, which the bank will not be able to deliver (because they will have gone bust!).
  • You could lose it all. Structured Notes aren’t generally principal-guaranteed – meaning you stand to lose all your investment if certain (usually quite complicated) financial factors come together.
  • You can get caught holding a Structured Note that you can’t sell. If the market of the assets on which your Note is based crashes, you will need to get out fast, and it likely that you will face problems getting them off your hands.
  • You could miss out on dividend payments. Over any given period, investment in an index using an ETF or fund would involve any dividends being re-invested. This doesn’t usually happen with Structured Notes, and the difference in return you could miss out on could be as much as five per cent or more.

The big pictured for the expat investor

There are plenty of ‘structured’ products that don’t involve the high-risk derivative basis of Structured Notes. It’s not just the high risk that’s the problem here. Structured Notes are complicated and confusing.

The bottom line is that investing as part of a wider holistic strategy cannot involve gambling your entire seed fund according to something you find hard to understand. The level of uncertainty that’s built in to Structured Notes as a consumer product make them a dark horse we can all do without.