Morningstar - Q3 2020 - 42

less than full payment. A sizable amount of
results showed losses of 25% or more.

Strategies

$360 400 440 480
Total Value of Payments
EXHIBIT 2

notes in our sample group were callable. If an
issue is called, the noteholder generally
receives the principal back but won't receive any
additional coupons or future payoff. Investors
should also keep in mind that issuing banks
will call the notes when it's in their own best
interest-not the investor's.
This naturally leads to the issue of autocallable
securities, which have become increasingly
popular in recent years. These securities will
typically be called at par if the underlying security
closes at or above the initial share price
on a given date (typically measured quarterly).
That basically guarantees that investors won't
participate in upside returns, although the
autocallable feature sometimes doesn't kick
in until after a certain period, such as one year.
Theoretically, investors should be compensated for
call risk with a higher yield to maturity, but
it's not clear if investors purchasing structured
notes are being adequately compensated
for the embedded call risk in most products. This
makes callable structured notes more difficult
to use in a portfolio because the term to maturity
is essentially unknown.
Worst-Performing Isn't the Best
Yet another mind-boggling aspect of structured
products is the way they work when returns
are tied to more than one index or underlying
security. In almost every case, the final payoff
investors receive is based on the performance of
the index with the lowest returns. This "worstperforming" structure is surprisingly common; in
fact, about half of the issues in our sample
group have more than one underlying index
or security, and all those issues were set up with
worst-performing payoff profiles.

It's hard to think of another example where
investors would voluntarily purchase something
that promises to give them the worst of
multiple outcomes. The fact that investors don't
naturally seek out products tied to the weakest
link in a series of assets suggests a fundamental
problem with this structure. It's like a perverse
form of diversification where investing in
something linked to multiple assets leads to a less
desirable outcome for the investor. In fact,

Morningstar Q3 2020

520

560

600

640

680

720

760

800

840

880

920

960 1,000 1,040

A Study in Underperformance Research on yield-enhanced notes found years of
poor performance relative to a 60/40 portfolio.
Yield-Enhanced Notes Return

60/40 Stock/Bond Portfolio Return
30%

11.65

11.21
5.22

6.08

5.28

18.62

18.25
11.29

1.62

4.40

2.03

10.60
1.05

1.80

-5.38

-3.09

-9.72

-9.75
-10

-20.10

-20
-23.70

2006

2007

2008

-30
2009

2010

2011

2012

2013

2014

2015

Note: Data includes structured products issued in the U.S. between January 2006 and September 2015.
Source: Vokata (2018).

it's hard to understand how anything explicitly
structured to deliver returns based on a worstperforming underlying asset could be considered
to be in an investor's best interest.
Lack of Liquidity
Investors should also be aware of the lack of
liquidity associated with structured notes.
Although there are some markets (mainly in
Europe) where these products trade on exchanges,
they're not exchange-traded in the U.S.
Investors purchase them at issue and then hold
them either until maturity or until they're
called away by the issuer. There's no easy way
for investors to trade these securities before
maturity other than working with a broker to try
to find a buyer in the private market (which
may not be possible). There is also a possibility of
the issuing bank buying the note back, but
the issuer has no obligation to do so.

Because there's no public market for these
securities, it's also very difficult for investors
to find information on the actual value of a note
before maturity.

Performance
This lack of information also makes it difficult to
evaluate how structured notes have performed
as a group. Perhaps for that reason, the question
of structured notes' performance has become
an attractive puzzle for academic researchers. It is
a labor-intensive challenge. Because issuers
aren't required to report on a note's performance
after issuance, researchers have to piece together
performance records by analyzing each issue's
terms and conditions to map out how it would
perform given actual market performance over the
life of the note.

We highlight three pieces of research.
We start with the research published by the
Securities Litigation and Consulting Group, a law
firm started by a former academic and SEC
economist Craig McCann. In a paper published in
2014, he and his colleagues analyzed more than
20,000 structured products issued since 2007
(Deng, Dulaney, Husson, McCann, and Yan,
2014). The researchers constructed a performance
index for structured notes as a whole, as well

Morningstar - Q3 2020

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