Bringing structured notes from financial bets to managed investments

By Ari Brandes

Structured notes have existed in the financial marketplace for many years, but they are still far from mainstream investment vehicles, especially for retail and high net-worth individual clients. Structured notes are often viewed as exotic, complex and illiquid, characteristics also used to describe the types of financial activities that have been blamed for the credit crisis.

Prompted by the great profits that financial institutions can realize by bringing structured notes into the mainstream, this article proposes a new note structure that operates like a managed investment rather than a single exotic bet and that is structured to help decrease the potential sting that exposure to just one stock or index, as through a structured note like a reverse convertible, can lead to.

This new product, which I call the "managed growth note," capitalizes on two important facts:

• Investors in fixed upside bull notes, such as reverse convertibles, benefit from holding as diversified a pool of such notes as possible (at no detriment to issuers and at no extra cost to holders); and

• Investors tend to want to "buy low and sell high," meaning that investors should, looking at the market broadly, be more bullish after market declines and less bullish after market rallies.

Thus, the return of the managed growth note is based on an index that periodically rebalances its economic exposure according to market performance during the period preceding each rebalancing period.

More specifically, the investor's money is synthetically reallocated between various types of bull notes based on whether, and by how much, the market has increased or decreased during the prior period.

Additionally, the investor's principal is synthetically allocated between bull notes that reference underlyings that are as negatively correlated as possible, which should decrease the probability of a loss upon maturity.

In sum, the note proposed in this article brings bull notes beyond seemingly exotic bets and toward investments, which should entice more investors to utilize structured notes in place of other investment vehicles and asset classes.

Building blocks

The managed growth note allocates between three types of bull notes, which will be referred to as sub-notes because they comprise the wider product. The three types of sub-notes are:

• A capped leveraged upside bull note with a 5% downside buffer (Figure 1 - "aggressive bull note");

• A principal-protected capped leveraged upside bull note (Figure 2 - "cautious bull note"); and

• A fixed upside bull note with knock-in downside risk (Figures 3a and 3b - "moderate bull note" or simply "reverse convertible").

The following graphs represent the payoff structures of the three sub-notes. The blue lines indicate the payoffs of the sub-notes; for comparison, the dotted lines indicate the payoff of a non-leveraged direct investment in the underlying. In regards to Figures 3a and 3b, Figure 3a represents the payoff of a moderate bull note if the put knocks in, and Figure 3b represents the payoff if the put does not knock in.

[FIGURES]

In this article, these notes have terms of six months, but backtesting should be performed in order to determine how long each rebalancing period should ideally be - and, hence, how long the terms of the sub-notes should be - in order for the managed growth note to capitalize on rebalancing the investor's economic exposure most advantageously.

Additionally, the sub-notes reference equities the dividend rates and volatilities of which should be as low as possible while still ensuring an enticing-enough potential upside.

Operation of the managed growth note

The client pays some amount (e.g., $100,000) for a note with a term of some multiple of six months (e.g., four years). Upon issuance of the notes, the client's $100,000 is synthetically divided in two with 50% being used to purchase a moderate bull note on one broad market index and the other 50% being used to purchase another moderate bull note on another broad market index.

Due to the capped upside of a reverse convertible, diversifying the investment of the client's money should only decrease the probability of the client losing money overall without costing the client or the issuer anything.

We will look at each of the two moderate bull notes as representing two separate streams of investment. Looking at each sub-note separately, when the two moderate bull notes mature, the proceeds of each moderate bull note - including what would have been paid out as a coupon - will be invested in either (1) another moderate bull note, (2) a cautious bull note or (3) an aggressive bull note referencing the same underlying.

If markets have risen sharply, a cautious bull note will be purchased. If the markets have risen moderately or fallen moderately, another moderate bull note will be purchased. If markets have fallen sharply, an aggressive bull note will be purchased. As this decision tree illustrates, a contrarian investment theory (with the assumption of a bullish drift) underlies the management of the note.

Applying the above decision tree, if, for example, upon issuance of the managed growth note, $50,000 is invested in a reverse convertible referencing the S&P 500 index and $50,000 is invested in a reverse convertible referencing the Hang Seng index, upon rebalancing the proceeds of the S&P 500 index reverse convertible will be reallocated into another bull note referencing the S&P 500 and the proceeds of the $50,000 referencing the Hang Seng will be allocated into another bull note referencing the Hang Seng. If the S&P 500 has rallied sharply and the Hang Seng has risen only moderately, after the first reallocation period the client will synthetically be invested in a cautious bull note referencing the S&P 500 and a moderate bull note referencing the Hang Seng.

Potential variations

Some of the keys to the structure of the managed growth note are that it divides the client's money into multiple buckets that are as negatively correlated as possible and it ensures that what the client receives back upon the maturity of the note is not determined solely by the state of the markets between two points in time (i.e., what the client receives upon maturity is not based simply on the return of the underlying between the time of issuance and the time of maturity of the note). Further, the product follows the theory that, as markets fall, less and less downside protection should be purchased.

However, the following parameters may be modified to optimize the note:

• The length of the rebalancing periods. As mentioned, the ideal length of time between rebalancings should be determined through quantitative analysis;

• The number of sub-notes that the managed growth note synthetically allocates the investor's capital between. The note may allocate between as many sub-notes as possible (not just two) in order to maximize diversification;

• Whether the note should permit allocation into a bear note, rather than just bull notes, if the relevant underlying appears to be trending so significantly downward; and

• Whether the note should be structured to periodically pay a coupon and, if so, whether the note should categorically pay a coupon or whether it should only pay a coupon after a rise in the value of the underlyings during the prior period. One appeal of reverse convertibles is the characteristically high coupon. Some clients prefer coupon-paying instruments while others are willing to forgo current income for greater gains at maturity (there is, of course, a trade off).

In order to find a middle ground, the managed growth note could be issued with a guaranteed coupon that is slightly above the coupon on a bond of comparable duration from a comparably rated issuer but a coupon the amount of which is less than the total coupon that the client would receive had he invested directly in the sub-notes, assuming that the sub-notes were structured to periodically pay a coupon.

Alternatively, the managed growth note could be structured to provide for a coupon only if the underlyings of the sub-notes rise during the prior period, which would anchor the client to the fact that, in rising markets, the client will receive a coupon plus an increase in the value of his managed growth note and, in declining markets, the client will be reinvesting his coupon in order to take advantage of a decline in prices.

Marketing the note

In order to reach retail clients, it is necessary to successfully market the note to retail investment advisers and brokers. While marketing these notes to the ultimate purchasers is, of course, key, where those ultimate purchasers are retail investors it is important to also market the note to investment advisers and brokers, many of whom are not comfortable recommending structured notes that represent specific and seemingly exotic financial bets. Further, many advisers and brokers are simply less familiar with structured notes as they are with other investment vehicles, such as mutual funds, common stocks and corporate bonds.

Incorporating the managed function into the managed growth note would permit a broker to feel more comfortable that his client is not invested in an exotic and complicated product, but rather is invested in an investment that allocates the client's money according to a strategy that is understandable and that many people agree with.

The managed growth note is structured to appeal to the desire of many investors for principled management of their money. Of course, it is possible that investors could themselves reallocate their portfolios as their structured notes mature, but the managed growth note uses institutional expertise by way of a predetermined and tested algorithm to efficiently reallocate clients' money.

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