Your Life Simplified

Alternative Cash Flow from Structured Notes and Options

September 21, 2023

On this episode of Your Life Simplified, Michael MacKelvie, wealth advisor, is joined by special guest, Brett Kunshek, head of options and structured notes. They break down what structured notes and options are and dive into their complexities, different types of structured notes and which investors these may be right for. They’ll also cover why these are growing in popularity in the United States and the fees that come along with them. 


Michael MacKelvie: Structured notes have gained quite a lot of popularity in recent years. We are here with the head of options and structured notes at Mariner, Brett Kunshek, to discuss if this is something you should consider.

Brett, I think we should just jump right in and just establish, what are structured notes? And I think you’re probably someone qualified to talk about this since you deal on the trading side of things. So maybe just help us understand what are these products, asset …? Just what are these things?

Brett Kunshek: Yeah, structured notes can be confusing. They are technically over-the-counter securities, so not like a stock or even an option for that matter, where they’re exchange traded. So when you buy a structured note, you’re going directly to the issuers. Issuers meaning large banks, think like JPMorgan, Goldman Sachs. And we go and we tell them type of note that we would like to purchase and then they would give us the quote, meaning the terms of the note that they would give us on that type of note.

Michael: Okay. And I think naturally, then, an investor might hear that and wonder, “Okay, well, what is it that I could expect? Is this bank then going to pay me an annual interest for the rest of time? Is it a set period of time they’re going to do this? How does this look maybe in my portfolio?” Maybe just, if you could, touch on what this looks like from the investor’s side, what they could maybe expect with a product like this.

Brett: Yeah, so a structured note, somewhat similar to option, you can think of it as a way just to readjust that risk-reward structure. If you’re good with just owning stocks for the long term, and like what you’re getting and you don’t want, say, downside protection or a higher level of income, then you could just own stocks, right, and you don’t necessarily need a structured note.

But if you’re looking for different objectives, rather than just necessarily riding the wave of the market with stocks or ETFs or mutual funds, then this is a way to readjust those risk-reward parameters to maybe put them in the light of an objective that is more fitting for the client or something that they like better.

These notes, they look like, effectively, like a bond in the account. So you do see them in the account, they’re not something that sits outside of the custodial account. And they get priced daily, like a mutual fund. So you do see the price change once a day. And they come with a prospectus, and that prospectus details out the terms of the note. So sometimes people might think, “Well, I don’t even know what’s going on here.” Well, you have a prospectus that details exactly what’s happening with the note, what it’s tied to and how it will pay out at maturity.

Michael: Yeah. And I want to make sure that we get into some of the criticisms around structured notes, just like any asset class will face criticisms, I think one of them being complexity, the fact that most investors are maybe just… And these have gained incredible popularity in recent years. We know that they were very popular in Europe, but we’ve seen a landslide of assets kind of flowing towards them here in the United States as well just in recent years, as I’m sure you’re aware of.

And I think that criticism of the complexity is one that’s a story as old as time, right? An investment company maybe has a complex product the consumer or client or retail client doesn’t fully understand. And because of that, they’re maybe purchasing something that doesn’t make sense. Maybe if you could, help us understand, within this complexity, where might this make sense for somebody? Where does this not make sense? Where do you see these placed where they shouldn’t be placed? And where do you see this maybe make sense for somebody?

Brett: Yeah, definitely. It’s a fair amount to unpack there, so I’ll hit on each of those points. But structured notes in general, you’re right, they are a little more complex. What we’ve done, and the beauty of using structured notes at Mariner is we have a dedicated team to structured notes, right? We’re experts in this area, so we’ve distilled this down to just the note types that we like.

So you can do everything from very risky to very conservative, everything in between, crazy structures. But historically speaking, a lot of times notes, they were more prevalent in the broker world. And notes were sold to clients, sold more as a trade versus, “Hey, this is a great investment for your portfolio.”

Here at Mariner, we’ve distilled that down to just the note types that we think are very attractive and fit very well within our client portfolios. And I think that’s what makes a lot of the difference, right? Because, like I said, you can do crazy things with notes. You can do conservative things that are overly conservative, that really limits your return potential. The types we use, they’re typically either for growth or yield and provide a level of downside protection. So they fit in a couple of buckets in the alternatives universe, and we really like them relative to the other alternatives that you would say are competitors to what they’re looking to achieve.

Michael: I think that’s where it’s so crucial just for that advisor to be aligned with the client then in that case, because again, it’s impossible for somebody to fully understand any asset class to its deepest depths, if you will. And so, structured notes, just in the way that you’re describing it, can fit in a variety of ways in somebody’s portfolio, it can be many different things. And so, of course placing them is crucial and that’s typically what the advisor is for, is figuring out really where they should be placed.

I do think there’s another criticism that is worth touching on here. And that is just how these have been, historically, maybe a commissionable product or there’s a broker fee of some sorts and there’s fees that’s involved to where when you price in that fee, it maybe isn’t as attractive as the story that was told when it was first laid out to that investor, let’s just say. So I guess what are your thoughts on just the structures of fees? Because again, typical question here a client would have, how much does this cost? What’s the trade-off here? What does that fee structure look like for something like a structured note? And maybe what does it look like in the universe of structured notes?

Brett: Yeah, definitely. So with structured notes, you’re right, one of the main criticisms is, “Oh, this is a product that’s riddled with fees.” And I think part of that comes from the broker world, again, where they’re sold. And that broker will, a lot of times, embed a fee, anywhere from two to 4%. And that’s a hefty fee that’s going to reduce the terms to the client significantly. But that’s in the broker world, that’s not in the RIA world, where we’re a fiduciary. And we do not add in any additional fees. The only fee would be the client’s management fee, that they’re paying to be a client of Mariner. And then, the other fees that are in the note is the issuer charges a fee in those notes. Typically, it’s around a 50-basis-point fee and that’s a onetime fee.

Michael: So 0.5 of 1%. Yeah.

Brett: Yeah, 0.5 of 1%. And especially on the longer-term notes, if it’s a five-year note, well, now you’re down to ETF-like pricing. So every spot that there’s a fee, we’ve really driven that down to give our clients the best outcome possible.

Michael: Right, yeah. That’s, I think, crucial just to understand, with a way that a company like Mariner’s maybe set up where a little bit more product agnostic, there’s not a huge benefit to, or any benefit, really, let’s just say, to an advisor saying, “Yeah, we’re going to look at structured notes for this piece of the sleeve versus this.” They’re not making any more off of that recommendation.

All that’s obviously critical, if it’s any client that’s ever considering, “Okay. Well, why is this being recommended to me now,” right? “Is there some type of compensation that’s attached?” I think they should always be asking that question because it’s something that’s important to understand, if there’s any conflict of interest.

And in a way, these kind of remind me, they’re certainly different than indexed universal life. They’re certainly different, right? But in a way, the complexity of them and the story of, “Hey, you have the downside protection, and we’re going to potentially cap a little bit of the upside, you could get all this growth as well.” That story seems to be somewhat similar because with indexed universal life, there’s more complexity to it, and we know that those have just been positioned in ways that doesn’t make sense. So again, I guess help me understand somebody that this does make sense for, so we can avoid people maybe getting products placed where they shouldn’t get placed. Who would you say this makes sense for?

Brett: It really can make sense for a lot of clients that are looking for that downside protection or a higher level of income, say, an alternative income that’s producing maybe 300 to 500 basis points, or call it three to 5% higher than, say, Treasuries at the moment. So it depends on what the client’s looking for.

Who it’s not appropriate for is a lot of times we’re tying these to equity indices. Think the Dow Jones Industrial Average, the S&P 500. You don’t get the dividends. So you don’t get the dividend. And on our growth notes, it’s just tied to the upside participation. So no dividend, and there can be some illiquidity to them. Not illiquidity from the standpoint that we can’t trade out of it. Because frankly, there’s more than likely we can trade out of it. We actually trade out of a couple of these every month. But illiquidity from the standpoint of you have to pay a discount, you get out at a discount relative to that fair value. Usually that’s about a hundred basis points. So it would cost you a little bit to get out if you’re not intending to stay in until maturity.

So maturity on our yield notes is one to three years. On our growth notes, typically three to five years. So we want our clients to go into these with the mentality that we’re going to hold these until maturity if needed. Knowing that hey, we can get out of them if we need to, but that’s going to reduce that friction and costs of the friction if we hold them to maturity.

Michael: And that’s where, again, I think it’s such a vast universe, even just within structured notes, that perhaps the question I’m phrasing there of who does this make sense for is really just not even the right question. Because they can be built in so many different ways that it could be that structured notes make sense for somebody who’s looking for another diversifier, an alternative asset class that has… It’s not one-to-one correlated with either bonds or stocks, to provide just further diversification. It could be that somebody is looking for a satellite for additional alpha or growth in their portfolio. And so, there’s a wide variety of ways, just in listening to you talk about these, that they can be structured to where it’s difficult to say, okay, who is this specifically for? It very much is circumstantial, and each should be evaluating it within the grand scheme of things.

But yeah, they’re, I guess, a very interesting product in that it’s almost as if there’s a creation of predictability here. And we know that…

Brett: Exactly.

Michael: … anytime we say, “Okay. Yes, you could have the equity. That could go all the way up, but there’s always a chance that it could go down.” When you’re looking at structured notes, they’re trying to say, “Okay, hey. This, we’re going to buffer you potentially on the loss, up to a certain amount. We may or may not cap on the gain. There might be some fee associated with this, likely is some fee associated with this.” But there’s a price to that predictability that I think anyone can kind of understand, but at the same time, they really need to make sure they’re aware of, right?

So when there’s a trade-off, we understand that trade-offs do occur. Let’s just say you pay for something, there’s going to be a cost to it. The question, at the end of the day, is the value that it provides to you. And that’s where it’s, okay, I understand there’s maybe some cost, but what is it that I’m maybe getting back here? And again, I think that’s why it’s so critical that people spend some time to really make sure they understand how these things work if it’s being recommended to them.

Brett: Yeah, definitely. And I think, again, that’s where we’ve distilled it down to just the few note types that we like. So going back to your original question of what types of people would like these. Well, for the growth notes, it’s providing that downside protection. So clients that would like to have that downside hedge, right? To have protection on the downside of their equity exposure. So think your more conservative client that maybe went to cash because the market was volatile and hasn’t gotten back in, and, “Oh, man, the market came back now. Now I want to wait again until it goes back down,” but then it keeps going up and they need to get in, right?

Michael: Right.

Brett: Or just conservative clients in general who maybe don’t have the equity exposure that they need to have, because they need to have that growth in their portfolio. So it can be a behavioral tool, but overall, our growth notes fall in that hedged equity bucket.

So if you think of other hedged equity products, you’re exactly right, there’s a cost associated with that hedge. Typically, that downside hedge costs money. Or a lot of times, you’re capping yourself out on the upside. Because capping yourself out to help pay for that downside hedge.

Here, with the notes that we like and that we buy for our clients, they have a lot of protection in the downside. Why do we go out with that three to five years? Well, it’s to get rid of that cap on the upside. So we have 100% upside and a lot of times leveraged upside, anywhere from 120 to even 160, 170, 180% upside participation. Now, you need some extra upside participation to overcome not getting the dividend. So like you said, to your point, there’s some different quirks about it that you need to understand. But again, that’s why we’re here. We have those types of notes that we’ve really distilled down to say, “Hey, this is what’s really attractive.”

Michael: Right. And when you say three to five years, just from the investor’s vantage point, does that mean they’re looking at their statement and they see, “Okay, I have this note that’s three years long. I’ll get an interest payment or a coupon of sorts each year for that period of time.” Or how does that function for them, if you could just explain it from their vantage point?

Brett: Yeah, so let’s break it into our two types of notes. Our growth notes have just downside protection, and there’s no cash flows off of those. So if you have a three-year maturity or five-year maturity, you’re not going to get any cash flows off of those. It’s just the upside participation. So maybe at the end of five years that note says, “Hey, you should get your principal back plus 65%.” Then that’s what you would get back at maturity and nothing prior to that. Those are typically three to five years, our growth notes. So again, that’s some of the give and take, right? That’s the trade off, is you’re going out further in time to get this attractive structure.

Now, our yield notes, those are in the one- to three-year range. So those are shorter term, and those do, hence the name, yield, those have a coupon associated with them that are usually paid monthly or quarterly. So you would get that monthly or quarterly coupon payment until that maturity based upon the terms of the note.

Michael: Right. And that’s where I think it’s just so important, I’m glad you answered that the way you did, to understand that there’s just different types of notes, right? And you might hear somebody talk about a structured note just speaking to, let’s say, yield notes without maybe talking about the more growth-centric notes that are going to pay you essentially at the end of the note entirely, you’re not going to be collecting interest the entire time. So if there’s an income need, along the way that doesn’t really maybe make sense, it’s not as suitable from that because it’s a little bit less liquidity, at least with the intended goal of it.

So I think this has been really helpful. Another question, I guess just to maybe wrap up, is why do you think these products, these structured notes have become more popular just in recent years? What has caused… Is it just because it’s new? We’ve seen that story over time. But they’ve been popular in Europe for a long period of time, but there’s been this rise in popularity here in the United States with structured notes. What are the forces that have kind of led to that, as to why more and more people are hearing about these and investing in them now?

Brett: Yeah, I think there’s several factors at play there. But like you said, they’re very popular over in Europe and Asia. Here in the U.S., they’ve actually been around for many decades, but the popularity hasn’t ramped up until, call it the last decade.

And so, here in the U.S., for rough terms here, in 2010, there was about 40 billion in issuance of new notes. In 2022, there was a hundred billion of issuance in new notes, and there’s about 2 trillion worth of these notes issued worldwide. So the U.S. market is actually just a fraction over the overall market.

Why is that? Well, I think partially because a lot of times, like I was saying earlier, they used to mainly be in the broker world, and they were sold. And then you saw some unfortunate things happen, maybe some bad actors, and I think they did get a bad rap there for a while. Now more registered investment advisors are using them, like Mariner, and they’re taking a more fiduciary approach. And then there’s also some companies in the middle area that are helping facilitate this.

We have a partner with Case. And Case has done a great job promoting notes and just, in general, using them in the right way. And I feel, again, we use them from a wealth management perspective. We don’t look at this as, “Hey, here’s a cool one-off trade. We’re going to make a quick buck.” That’s never how we do anything. We literally look at it as, “Hey, how can we use these notes to better achieve our client’s objectives?” If we can get to our client’s objectives with a more simplistic portfolio, with stocks, bonds, cash, great, you can do that.

But especially when we get to the high-net-worth, the ultra-high-net-worth area, a lot of times our clients are looking for something different. Whether that is a different risk-reward structure or whether that is more upside participation, more income, downside protection, what have you, we can really zone in and that’s where these become attractive.

So to your point, why would a client want these? Well, you can more or less not define your exact outcome. It’s not saying, “Hey, this is going to be up X percent.” But it really does help define it, right? We have a certain amount of protection, we have a certain amount of upside participation, or we have this much higher coupon. Our coupons are in the nine to 11% range now, which is pretty attractive when you compare it to the alternative income universe.

So in alternative income, you have the higher yields. But in nothing else that I’m aware of, you have the explicit downside protection. Usually, the downside protection is just because it’s higher up on the capital structure. It’s not equity. You’re either preferred stock or you’re some sort of fixed income. Here, you have that explicit protection, and it’s much less interest rate risk.

Last year, these types of coupon notes that we use were up, and up nicely up seven, 8% versus bonds that were down 12. So it can even be a differentiator within your income-type of investments. And that’s just one example, I could go on, but of how these can be a differentiator and define those terms of the investment that a client may like a lot more than just a stock or a bond.

Michael: Right. Yeah. And they’ve evolved over time, and the way that they’ve made their way to the client has evolved over time. And perhaps that is where they’ve become maybe slightly more attractive, is the ability for the client to maybe have these as part of their portfolio, either in an easier way or just in a more affordable, less expensive way, which we’ve seen just for the entire investment industry in general over time.

Well, I really appreciate your time here, Brett. Thank you so much for going through this. If you’re listening on YouTube, Spotify, or wherever you’re listing, make sure to hit ‘Subscribe’ so you don’t miss out on more industry insights from industry professionals like Brett here. Thanks again. You guys take care.

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