Ever since 2012, I’ve invested in equity structured notes to provide for some downside protection. Structured notes have sometimes gotten a bad reputation because they may be complex and expensive. However, just because you don’t understand something doesn’t mean you should burn it at the stake.
In hindsight, I didn’t need downside protection since the S&P 500 has performed very well since I left work. However, because I didn’t have a steady paycheck, I lacked the courage to invest significant sums of money in the stock market. If it weren’t for equity structured notes, I may have just kept the funds in cash or bought even more real estate instead.
For downside protection, an investor in a particular structured note usually has to give up something. That something is usually dividends or capped upside. As a result, these notes tend to underperform during a bull market. But not this one.
Let me share a structured note that just matured as a case study. You can then tell me how bad it really is.
The Upside Of Investing In A Structured Note
On September 10, 2021, $135,270.14 hit my checking account. It turns out a 5-year S&P 500 structured note I bought in September 2016 came due.
Given five years was so long ago, I didn’t remember the details of this note. So I asked my private client manager at Citibank to remind me. He got back to me with the original prospectus and said it was an S&P 500 barrier note with the following terms:
- Barrier level: 70%
- Leverage factor: 150%
- Investor must forgo all dividends
In other words, this S&P 500 structure note would provide 30% downside protection if I gave up dividends. So long as the S&P 500 was down 30% or less, I would get 100% of my money back upon maturity in five years. If the S&P 500 closed down worse than 30% in five years, I would get the exact same downside loss.
On the flip side, I would get a 50% boost to my overall return after five years if the S&P 500 ends up positive. In other words, if the S&P 500 closed up 50% in five years, I would get a 75% return. Not bad!
Below is a chart that highlights how this structured note worked.
With these types of conditions, I understand why I invested in the note. Unfortunately, I only invested $52,000. Still, the investment was better than buying an expensive new car I didn’t need.
The note’s 5-year IRR equaled 21% compared to a ~16% IRR if I had invested directly in an S&P 500 index fund. In other words, if I had invested $52,000 in an S&P 500 index fund on September 10, 2016, I would have ~$102,000 today. Due to investing in the structured note, I made about $33,270 more ($135,270.14).
The positive of investing in a structured note is not only getting downside protection but sometimes, getting extra upside participation as well.
More importantly, this structured note gave me the confidence to put $52,000 of capital to work. I remember back in September 2016 I was feeling just so-so about the stock market. We went through a correction in late 2015 and another one in early 2016. These corrections felt like mini tremors before a potentially big one hits.
Further, my wife had also left her full-time job 1.5 years earlier. Therefore, my household was really without any steady income or traditional work benefits.
However, due to the attractive conditions this note provided, I felt like it was worth the risk. At 39 years old, I was too young to not stay invested. Further, Financial Samurai was growing.
In retrospect, I wish I had invested a lot more!
First Downside To Investing In A Structured Note: Mental Burden
After investigating the origin of this structured note payout, I came to realize there are several downsides.
I now have $135,270 more in cash to deal with. Should I use the proceeds to pay down mortgage debt? That always sounds like the responsible thing to do. I have more mortgage debt now given I bought a home in 2020.
Should I re-invest some of the proceeds back into the S&P 500 without any downside hedge (naked long)? It’s good to stick to my desired equities allocation as a percentage of net worth. But valuations are so expensive and we haven’t had a big correction in a long time.
Or maybe I should invest more in real estate crowdfunding to earn more passive income. After all, this structured note provided zero dividends. Therefore, investing in real assets may not only help dampen volatility, but it should also boost retirement income by potentially $3,000 – $10,000 a year.
Thinking about what to do with the money is a mental burden, which is one of the reasons why I enjoy investing for the long term. Private investments with 5-10-year lockups are ideal. Although, once I reach 60 years old I will likely reduce my exposure to private investments given I might die before the investments exit.
Second Downside To Investing In A Structured Note: Tax Liability
Figuring out what to do with the cash is one thing. However, perhaps the biggest downside to investing in a structured note is a new tax liability every time a note matures.
I’ve discussed in the past about the importance of accurately tracking your passive income for better tax management. However, once again, I’ve failed to take into account this liquidity injection.
I knew in the back of my mind something was coming. But I didn’t get the amount right. Further, I thought this note was only purchased in my rollover IRA.
As a result, my upcoming tax bill will equal $135,270 – $52,000 = $83,270 X 15% = $12,490.5 federal. Then I’ve got to pay long-term capital gains tax for California. Bummer.
Third Downside To Investing In A Structured Note: No Control Over Exit
When you invest in stocks or real estate, you can control when you invest and when you sell. When you invest in a structured note, you must concurrently decide when to sell and when to exit sometime in the future.
In 2016, I felt there was a decent chance the S&P 500 would be higher in five years. However, what if the S&P 500 was up 100% in five years. But the day before the note was to mature, the S&P 500 crashed by 51%. I would have ended up losing money during this long duration!
If it was up to me, I would happily let this structured note ride for another five years. Sure, there will probably be multiple corrections during this time. However, I like its incentives. In addition, once the money is locked up in a long-term investment that has early withdrawal penalties, the stress of managing the money disappears.
At the very least, I would have liked for the note to have matured in 2022, the year I plan to re-retire and make less money. 2021 should end up being a financially great year because the economy will have rebounded strongly from a depressed 2020.
A Complicated Net Worth Needs To Be Managed
After doing the final edit on this post, I realized I actually did end up betting big on this note through my rollover IRA. All this time, I was playing Monday-morning quarterback wondering why I didn’t invest more. Having investment systems work!
When this note matured in my taxable portfolio, the proceeds eventually hit my checking account. As a result, it was easy to tell that something had exited – like an automatic reminder.
However, when a note exits my rollover IRA, the proceeds just sit there and my portfolio balance looks the same. Therefore, even though I remembered a note was exiting in September 2021, I confused the note that exited in my taxable portfolio with the one I held in my IRA.
Upon checking my rollover IRA realized gains/loss tab, I noticed the following. $150,000 invested on 9/07/2016 and $390,202.34 exited on 9/10/2021. Gains $240,202.34, +160%. I had strategically invested the most in a tax-efficient account.
I’ve now got to figure out how to reinvest $390,202 in proceeds with stock market valuations at nose-bleed levels. But in reality, I’ve got to figure out how to reinvest $525,472 given I’ve got to add the proceeds from my taxable portfolio.
Luckily, there is no taxable event with the $390,202 in proceeds. Otherwise, paying taxes on the entire $323,472 in profits from both investments would be very painful.
The key lesson here is to take advantage of rollover IRAs, Roth IRAs, and backdoor IRAs. If you like to trade, invest in structured notes, or invest in private investments, IRAs are your friend.
Just make sure to invest responsibly. It can sometimes feel easier to swing for the fences with your tax-advantageous accounts because you can’t access them without penalty until you’re much older.
With your taxable portfolios, you should hold your positions for as long as possible. Your taxable portfolios should also be one of your main sources of passive income.
We’ve been in a bull market for so long that we’ve become accustomed to just buying and holding. So long as you hold, you don’t have to pay capital gains taxes. The only tax you will have to pay is on the dividends if any.
On the bright side, maybe this payout is a good thing. After a 160% increase in five years, perhaps it’s time to take some chips off the table. Using the money to pay down mortgage debt to lock in a guaranteed return sounds like the most responsible thing to do.
Where To Invest In Structured Notes
If you want to invest in structured notes, check with the financial institution where you have your brokerage account. Most large institutions like Citibank, JP Morgan Chase, Goldman, offer structured notes.
It also helps to have a financial advisor look for appropriate notes for you. I’ve got very little time to look for new notes. I just tell my private client manager to highlight ones that have attractive terms. From there, I make a decision.
Before investing in any structured note, you must know how it works. The prospectus should go through various scenarios. If you don’t fully understand how the note works, don’t invest in it.
Finally, structured notes also cost money to buy. The cost usually hovers around 1% of the purchase amount versus free if you buy a stock or ETF.
Continue To Track Your Liquidity Events
As an investor in long-term investments, it’s best to put them all in a spreadsheet. One column should show when you invested and another column should have the exit date. You can also put calendar reminds to alert you to when an investment will mature. This way, you can better plan your life.
At the end of the day, you invest to potentially make more money to save time. If you know a couple of investments are exiting one year, you can plan to spend less time making money and more time doing something more meaningful.
To track my complicated net worth with over 30 financial accounts, I use Personal Capital. Personal Capital lists all my accounts I’ve linked up on my dashboard so I always know what’s happening.
Ideally, I will reinvest the proceeds into another structured note with similar terms. This money comes out of my equity exposure. Unfortunately, I haven’t been able to find similar ones for the past several years. Therefore, I’m going to patiently bide my time until better opportunities come along.
Readers, anybody invest in structured notes or private investments? How do you manage your time, income, and taxes with these occasional liquidity events? Besides fees, what are some other downsides you can think of when it comes to investing in structured notes? Has a long-term investment saved you from selling too soon?