Structured notes, also known as structured investments, are on the rise as financial advisors look to increase returns while also looking to mitigate risk in their clients' portfolios. Structured notes are not necessarily an asset class, but rather are unsecured debt obligations of an issuer, typically constructed from a zero-coupon bond with a package of options along with built-in origination costs to create a value of alone. Structured notes seek to enable investors to achieve a defined payment that may be linked to an index, a stock or even the price of gold. Structured notes can provide exposure to public markets in a hedged or leveraged manner, typically linked to underlying assets, such as currencies, interest rates and market indices. The notes may target objectives such as yield, growth and/or protection, aiming to bridge portfolio gaps with a lower barrier to entry.
According to a recent one CAIS-Mercer survey of more than 250 independent financial advisors, almost a third of respondents currently allocate structured notes, with a quarter planning to increase their allocations in the coming year. The trend is on track to continue given the growth of the market and the versatility and flexibility of structured notes—in the past three years alone, total U.S. structured note issuance volume grew over 68% to approximately $130 billion dollars in 2023.
The History of Structured Investments
Investors in European and Asian markets were leaders in the issuance of structured notes beginning in the 1980s. By the 1990s, it took off in the US as financial institutions looked for innovative ways to meet investor demand for customizable investment strategies. Historically, these strategies were adopted primarily by institutional investors and high net worth individuals. However, structured notes have since become more accessible to the independent wealth channel as technology has made it easier for financial advisors to access these strategies and distribute them to client portfolios.
Approval of these investment tools is still low among advisors in the US compared to European and Asian markets, and is growing significantly. The first step to getting an advisor to adopt structured notes is to help them understand how the strategy can benefit clients and educate them on the applicable risks.
Unpacking Structured Investments
Structured notes can serve as a multiple vehicle to target different investment objectives.
They can generally be divided into three broad product categories focused on growth, yield and protection. Within these categories, advisors can select specific offerings from issuing banks that target their desired market exposure, downside protection, upside potential and time to maturity. Alternatively, advisers may seek to work with issuing banks to customize and tailor a structured note to help meet their clients' specific investment objectives, address their risk-reward profile and express views their market. Structured notes can be at the core of defined outcome investing, potentially enabling the advisor to play offense and defense in the markets.
Structured portfolio investments
As some advisors look beyond the traditional 60/40 portfolio, they may consider implementing structured notes as a differentiator in their practice to attract new clients and gain more portfolio shares with their existing clients.
Advisers tend to view structured notes in one of three ways — as part of the alternatives sleeve, as a complement to their clients' core bond fixed income allocation, or to hedge their equity positions.
For advisors new to alternatives, structured notes can serve as a gateway to the space due to increased access with lower investment minimums and lack of accreditation requirements. For advisors who already use alternatives in their clients' portfolios, structured notes can supplement their fund allocations and further reduce portfolio gaps.
Additionally, rather than buying a single position, advisors can consider raising structured notes by building a strategy over time. By scaling structured notes, advisers can aim to address concerns about market volatility by hedging timing risk, the underlying asset and reinvestment risk when cash matures at different time periods.
Recently, separately managed structured accounts are gaining popularity due to their professional management, potential for institutional pricing and mitigation of operational burdens.
Additionally, advisors have recognized that when alternative funds and structured notes are paired together in a client's portfolio, an advisor can tap into the public and private markets. Structured notes offer more flexibility when compared to alternative fund investments, thereby offering advisors the opportunity to settle for more specific investment goals.
Key Risk Considerations for Structured Investments
Before investing in structured notes, it is important to understand their inherent risks and consider some of the implications of holding note positions.
As a general matter, structured notes carry certain investment risks, including, but not limited to, market risk, complexity, illiquidity, call risk and credit risk.
For example, because structured notes are generally unsecured debt obligations of an issuer, any payment or delivery to be made on a structured note, including any repayment of principal, depends on the issuer's creditworthiness and ability to fulfill his obligations. Because structured notes are linked to the performance of an underlying asset, the value of the note may rise or fall due to market factors such as volatility, interest rates, and economic or political changes, and investors may lose a portion of substantially or all of their initial. investment. Some notes have a call feature which means if a note is called early, there is no guarantee that the investor will be able to reinvest the proceeds at the same rate of return.
Looking Forward
With more eight in 10 financial advisors Expecting to increase allocations to alts by 2025, structured notes are likely to grow in popularity. In recent conversations with advisers, many have increasingly noted the emerging link between funds and notes – with complementary objectives such as yield, growth or protection, notes can be considered alongside alternative funds and help overcome portfolio gaps with a lower barrier to entry.
If you're not educating your customers with structured notes, someone else is. Advisors can be well positioned to reap the potential benefits of these strategies by doing research and understanding how they might fit into specific client portfolios.
Marc Premselaar is Senior Managing Director, Capital Markets, CAIS Capital LLC