Morningstar - Q3 2020 - 43

as subindexes covering its various subsectors.
The conclusions they come to are not kind to the
product line: "The ex-post returns of U.S.
structured products are highly correlated with the
returns of large capitalization equity markets
in the aggregate but individual structured products
generally underperform simple alternative
allocations to stocks and bonds."
Our second piece of research (Vokata, 2018) is
a more recent paper that evaluated performance
for more than 21,000 notes issued between
2006 and 2015. The paper focuses on yieldenhanced products, which typically promise
a healthy coupon provided that the underlying
asset-an index, a basket of indexes, or an
individual stock-meets certain performance
conditions. Vokata's findings point in the
same direction as the first study. Grouping notes
by the year of their issuance and calculating
returns over their horizon, Vokata arrives at the
results in E X H IB IT 2 . To put these results in
context, we added a comparison to a 60/40 stock/
bond portfolio (combining the S&P 500 for
stocks and the Bloomberg Barclays U.S. Aggregate
Index for bonds) that is a common reference
point for diversified portfolios.
Finally, Vanini, Maringer, and Pohl (2014) published
an analysis of more than 20,000 products issued
in Switzerland between 2008 and 2014. The
authors find that in general, the notes'
performance was positive in all years except for
2008 and 2011. The former of these two years
incurred particularly sharp losses of more than 40%
in some categories of the notes considered;
the performance during the 2011 European debt
crisis was mildly negative, with most categories of
notes losing less than 10%. A strong year was
2009, with some categories of notes posting
returns between 20% and 30%. In the remaining
years, performance was decently positive.
In evaluating those results, one needs to remember
that the authors only considered notes that
were tied to the performance of equities, either of
individual stocks or stock indexes. And here
the shortcomings of notes become apparent-they
tend to provide capped exposure to the upside
with only limited protection against losses. This
characteristic can be seen in the notes' experience

during the global financial crisis of 2008-09
and the more limited European debt crisis of 2011,
and it's being replicated during the 2020
coronavirus market crash. The Swiss exchange SIX,
which was the basis for the Swiss study's
universe, has constructed three indexes for
structured notes: the Yield Enhancement Index,
Capital Protection Index, and Participation
Index. They experienced drawdowns of 21.8%,
15.1%, and 25.9%, respectively.
Given the results of these three studies, one
would be hard-pressed to find a compelling
rationale for investing in structured notes. Either
the returns have been very poor, or worse
than a simple balanced portfolio, or overly tied to
the performance of the equity markets, particularly
in times of serious stress.
Sold and Not Bought
Structured notes have often been subject to
bad sales practices, mostly involving suitability
or inadequate disclosure. Both the SEC and the
Financial Industry Regulatory Authority have
flagged structured notes as an area that involves
potential pitfalls for investors. The SEC undertook
a detailed review of structured products starting
in 2007 and examined the structured-products
business of 11 broker/dealers. The report found a
number of deficiencies related to disclosure,
compliance, and sales practices (SEC, 2011). After
the publication of the report, Merrill Lynch,
UBS Group UBS, Wells Fargo WFC, and other firms
have paid fines and settlements related to
their firms' sales and disclosure practices for
structured products.

Structured notes have not only been subject to
sales practices that can end up misleading
investors, they also appeal to investors' cognitive
biases, errors in thinking that can lead to
making decisions that aren't in their own best
interests. Loss aversion probably looms largest
with structured notes. Behavioral science
researchers have found that investors have an
outsize negative response to losses; people
tend to experience about twice as much
psychological pain from a loss as they do pleasure
from an equivalent gain. In practice, this can
lead investors to overvalue the downside
protection offered by structured notes while

disregarding the potential for positive returns
they're often giving up.
Too Many Problems
Structured notes might seem like they could fill a
useful role, combining above-market yields
with downside protection and (in some cases) the
potential for upside returns. In practice, though,
few of them deliver on this promise.

In their current form, structured notes have
too many problems to make them worth
recommending for most investors. They're opaque,
complex, and difficult to understand. The
embedded fees have cut into returns, generally
leading to returns that are either negative
or below market benchmarks. They're often
described as having a risk profile between stocks
and bonds, but their performance patterns
are more linked to equity returns. Even worse,
they're often tied not just to equity returns,
but to price movements on a specific stock. And
those stocks tend to have price volatility (as
measured by beta) that's well above average. That
makes structured notes poorly suited to
investors seeking a higher-yielding alternative
to CDs and other traditional fixed-income
securities. K
Amy C. Arnott, CFA, is a portfolio strategist with
Morningstar Research Services.
Maciej Kowara, Ph.D., CFA, is a strategist with Morningstar
Research Services.
References
Deng, G., Dulaney, T., Husson, T., McCann, C., & Yan, M.
2014. "Ex-Post Structured Product Returns: Index
Methodology and Analysis." Working Paper, Securities
Litigation & Consulting Group. Aug. 20.
Prospect News. 2020. Structured Products Weekly,
P. 2. April 8.
U.S. Securities and Exchange Commission. 2011. "Staff
Summary Report on Issues Identified in Examinations
of Certain Structured Securities Products Sold to Retail
Investors." July 27.

Vanini, P., Maringer, D., & Pohl, W. 2015. "Structured
Products: Performance, Costs and Investments." Swiss
Finance Institute White Paper. June.
Vokata, P. 2018. "Engineering Lemons." Ninth Miami
Behavioral Finance Conference. June 27.

morningstar.com/lp/magazine

43
http://www.morningstar.com/lp/magazine
Morningstar - Q3 2020

Table of Contents for the Digital Edition of Morningstar - Q3 2020
