A client recently forwarded me an email that his father (we’ll call him Joe) received from his Morgan Stanley advisor. It contained a recommendation to invest at least $150,000 into this structured note. The pitch from the advisor was simple:
As long as the S&P 500, Russell 2000, and Nasdaq avoid a 30% decline from their level at the start of each quarter, the note will pay a 7.2% annual interest rate. The note lasts until December 2023, at which point you’ll receive your principal so long as all three indexes are at least 70% of their starting level. If any of them are not at that level, then you suffer the same loss as the worst performing index.
In other words, he would lose his principal. In addition, the advisor casually mentioned that the note is callable every quarter at Morgan Stanley’s discretion.
It sounds like a good deal, right? 30% declines are outlier events, and if we avoid those over the next 2.5 years, we can book a 7.2% annual return with no downside. The advisor ended the pitch with, “We continue to be opportunistic in getting yield, and notes like this are nice hybrids between stocks and bonds.”
Joe received the email on Wednesday night, and the deadline to invest was Friday morning. An extremely busy man, he hardly had the time or expertise to comb through the 34-page, jargon-filled prospectus. Trusting his advisor, whose email signature proudly boasts that he is a top-ranked Wealth Advisor by both Forbes’ and Barron’s Magazines, Joe probably approved the investment, pleased that his “money guy” had dug up such a great opportunity.
What he didn’t realize was that he had just become a participant in a game rigged against him.
For us at Truepoint and Commas, structured products like this fall into the same bucket as non-traded REITs and a handful of other “investment solutions” – often better for the person selling the product than for the end investor. (And to be clear, these are products being sold for a commission – it’s important to be aware of the incentives at work here.)
Back to Joe – The most immediate aspect of the game that he probably wasn’t aware of was the cost to play. The advisor failed to mention the 2% up-front commission, amounting to $3,000 on a $150,000 investment. That information was buried in the prospectus that Joe didn’t have time to review. But maybe he would’ve decided to invest regardless? After all, there’s a difference between price and value, and if this were a superior product, perhaps it would justify the premium price tag. With that in mind, let’s dive into the expected return of the product.
I looked at historical data ranging from 1994 (first date data is available for the three indexes) to today. While a 30% decline sounds like a rare occurrence, it happened to at least one of the indexes 18 times out of 110 quarters (16%), which means the expected annual coupon is actually 6.05% (84%*7.2%). Further, if held in a taxable account (as was recommended to Joe), the coupons for this product are not taxed at the lower qualified rate but, the higher ordinary-income rate. In the top tax bracket, Joe will likely lose about 40% of the interest to Uncle Sam, reducing the expected after-tax annual return to about 3.63% (60%*6.05%).
Another important detail, buried in the fine print, is that this product tracks the price-only indexes, completely ignoring the impact of dividends. This is common for structured products, and it makes a big difference. For instance, over the last 2.5 years, the S&P 500 price-only index is up 64% while the total return index (which includes dividends) is up 71%.
And while all these details add up to a significant erosion of expected return, the callable feature might be the ultimate “devil in the details.” Callable securities are always in the bank’s (in this case, Morgan Stanley’s) favor, and you don’t need to take my word for it. From the prospectus:
“It is more likely that we will redeem the securities when it would otherwise be advantageous for you to continue to hold the securities. On the other hand, we will be less likely to redeem the securities when the index closing value of any underlying index is below its respective coupon barrier level. Therefore, if we do not redeem the securities, it is more likely that you will receive few or no coupons and suffer a significant loss at maturity.”
Yes, it actually says that!
If you happen to be winning the game, they’ll end it prematurely. If you’re losing, they’ll let it drag on.
So, what if Joe is not enjoying the game? Perhaps he realizes that the odds are against him and wants to quit by selling the position. Well, Morgan Stanley sets the rules on quitting, too:
“MS & Co. may, but is not obligated to, make a market in the securities, and if it once chooses to make a market, may cease doing so at any time. The price at which you may be able to trade your securities is likely to depend on the price, if any, at which MS & Co. is willing to transact.”
Yes, it actually says that, too.
These games are a gold mine for banks. Their expert financiers shrewdly design the rules in their favor, and nobody would know all the little mechanical details unless they combed through the prospectus.
Contrary to the advisor’s pitch as “nice hybrids between stocks and bonds,” I’d argue that this product combines the worst features of each asset class. You get bond-like upside (expected after-tax annual yield is only 3.63%) with stock-like downside (fully exposed to a market crash). And it doesn’t even have to be a broad market crash – if large stocks or small stocks or tech stocks falter, you lose.
One thing is clear: Banks don’t create these structured products to meet the demand of retail investors desperate to buy them. Rather, armies of crafty investment professionals design these products, and savvy marketers sell them to unsuspecting clients.
Unfortunately, we still have some sharks in this industry. If you’re worried about being bitten, a good first step is to avoid structured products. Next, read about four ways to tip the odds in your favor. Finally, if you want a second opinion about these or other products, reach out to us! Between Commas and Truepoint, we can help anyone.
Prospectus: https://sec.report/Document/0001839882-21-008637/
Disclaimer: Truepoint Wealth Counsel is a fee-only Registered Investment Adviser (RIA). Registration as an adviser does not connote a specific level of skill or training. More detail, including forms ADV Part 2A & Form CRS filed with the SEC, can be found at TruepointWealth.com. Neither the information, nor any opinion expressed, is to be construed as personalized investment, tax or legal advice.