Structured Notes: Obstacles to Profiting Off Tech Stocks

Summary

WSJ Your Money Briefing

Episode: Structured Notes: Obstacles to Profiting Off Tech Stocks
Date: September 12, 2018
Host: J.R. Whalen
Guest: Ben Isen, Wall Street Journal Markets Reporter

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Overview of the Episode

This episode explores the growing popularity—and pitfalls—of structured notes, particularly auto callable notes tied to major tech stocks such as Facebook, Apple, Netflix, and Google. Wall Street Journal markets reporter Ben Isen joins J.R. Whalen to explain why these seemingly risk-mitigating investments often leave investors disappointed, especially when it comes to balancing risk versus reward in the volatile tech sector.

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Key Discussion Points and Insights

1. What Are Structured Notes?

• Definition & Purpose
  • Structured notes are complex financial products, often marketed to everyday investors, that use financial engineering to adjust the risk and return profile of stock investments.
  • Ben Isen explains:

    “These are products that are basically meant to transform the risk profile of an investment...by some form of financial engineering, you are taking this stock and perhaps you have less risk of principal losses but a little bit less risk of gains.”
    (02:17)

2. The Mechanisms of Auto Callable Notes

• How They Work
  • Auto callable notes are popular, particularly those tied to big tech stocks.
  • Investors receive coupon payments (similar to interest), but the note can be "called"—i.e., terminated—if the underlying stock rises above a certain threshold, often before the investor can realize the advertised high yields.
  • Isen highlights the mismatch between expectations and reality:

    “An investor might see this teaser yield that might advertise double digit annual returns, but the note is actually called in way less than a year. After a month or a few months...you earn a fraction of that.”
    (02:56)

3. Pitfalls: Fees and Underperformance

• Bank Fees Can Outweigh Returns
  • Structured notes often include hefty bank fees baked into the product.
  • Because the notes are called so quickly, the actual return for investors is often less than the fees they pay.
  • Memorable quote:

    "Sometimes these fees, or oftentimes these fees are higher than the actual returns that an investor gets because the note's outstanding for such a short amount of time."
    (03:48)

4. Impact of Stock Volatility

• Tech Stock Pullbacks Slow Down Calls
  • Recent pullbacks in certain tech stocks, like Facebook, have meant some notes tied to these stocks have lasted longer before being called, which can create opportunities for slightly higher returns.
  • Contrasting different stocks:

    “Facebook…taken a couple of big dives this year...Those notes get called at the earliest possible time [if tied to stocks like Amazon].”
    (04:29)

5. Structured Notes on Indexes vs. Individual Stocks

• Diversification Reduces Volatility
  • Some investors prefer structured notes linked to diversified indexes (like the S&P 500) rather than individual, more volatile tech stocks.
  • Isen notes:

    "The S&P is a little bit less volatile than an individual stock and you sort of have a better sense of how the note is going to perform...It’s a little bit more of a known quantity.”
    (05:00)

  • J.R. Whalen explains the advantage:

    "Because the index is more diversified, it might be a smoother ride up and down that could hold those notes in check."
    (05:24)

6. Remaining Risks

• Principal Loss Still Possible
  • Even with these notes, principal loss can occur, especially if the underlying falls drastically by maturity (e.g., 25-30% or more).
  • Isen cautions:

    “...If the underlying entity falls 25% or 30%...at maturity, you end up taking losses on par with the underlying. It’s a little bit more likely that a single stock will fall by that much than a big index which is more diversified.”
    (05:38)

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Notable Quotes

• Ben Isen on Risk and Reward:

  “You can make a lot of money, but you can lose a lot of money. The idea here is...less risk of principal losses but a little bit less risk of gains.” (02:17)

• Ben Isen on Auto Callable Notes:

  “The note is called and you basically earn a fraction of that yield. What we've found is that a lot of these notes…deliver a lot smaller returns than the stock itself.” (03:48)

• Ben Isen on Single Stock vs. Index Notes:

  “A single stock will fall by that much [25%-30%] more likely than a big index which is more diversified.” (05:38)

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Timestamps for Key Segments

• [02:17] — Definition and basic concept of structured notes
• [02:56] — How auto callable notes function and what “called” means
• [03:48] — Discussion on underperformance and bank fees
• [04:29] — How tech stock volatility affects note duration
• [05:00] — Why some investors choose index-linked structured notes
• [05:38] — Risk of principal loss with notes tied to single stocks

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Tone and Style

The episode maintains an informative but accessible tone, balancing financial jargon with practical explanations and concrete examples aimed at a broad investing audience. Both host and guest avoid sensationalism, focusing instead on clear-eyed analysis and actionable insights.

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This episode will be particularly valuable to individual investors interested in the complex trade-offs in structured products, especially those attracted to “safer” alternatives to direct stock investing in the tech sector.

Transcript

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[J.R. Whalen]

With your Money briefing. I'm J.R. whalen at the Wall Street Journal in New York. Investors are finding it hard to bet on big tech stocks and and avoid risk. We'll explain in a moment. First, these money and market stories you should know. In a sign of an increasingly tight labor market, the number of available jobs in the US exceeded the number of job seekers by more than 650,000 in July. And the number of available jobs in the US rose by about 117,000 to a seasonally adjusted 6.94 million in July. That's the highest level on record dating back to 2000. The tight labor market shown by an unemployment rate holding near a 17 year low is shifting more power to workers and increasingly they're willing to quit their jobs. In July, nearly 3.6 million workers voluntarily left their jobs. That's the highest level on record. And companies conducting credit checks on prospective employees is not new. But a new report from the National Bureau of Economic Research spells out how the standard can hurt low income Americans. The report says the pre employment credit checks can lead to what it calls a poverty trap whereby someone who is unemployed with poor credit might have a harder time finding a job. The report says the poverty trap is associated with a 2.3% wage loss per month over a 10 year span. Last year, Senator Elizabeth Warren of Massachusetts reintroduced a bill in the wake of the Equifax data breach that would prohibit the practice at the federal level. We're joined by Wall Street Journal markets reporter Ben Isen. Many investors turn to tech stocks and most notably Facebook, Apple, Netflix and Google to score profits, but would rather leave risk on the table. Now Ben, you write in the Journal that investors are finding it hard to do both. It involves structured notes issued by banks. What exactly are these notes?

[Ben Isen]

A structured note is a pretty complex type of product, but it's often owned by everyday mom and pop investors. These are products that are basically meant to transform the risk profile of an investment, like a stock. Think of the way a stock goes up, but it can also go down. You can make a lot of money, but you can lose a lot of money. The idea here is by some form of financial engineering, you are taking this stock and perhaps you have less risk of principal losses but a little bit less risk of gains.

[J.R. Whalen]

And some of this risk has a lot to do with how and when the notes are redeemed.

[Ben Isen]

Yeah. There's a very popular type of structured product these days called an auto callable note. And a lot of these notes are linked to some of these hot tech stocks like Facebook and Amazon and Netflix. And what happens basically is you earn a coupon much like a bond, you earn interest. But the note can automatically be called. Usually it's called if the underlying stock rises. An investor might see this teaser yield that might advertise double digit annual returns, but the note is actually called in way less than a year. After a month or a few months, a quarter, six months, the note gets called and you earn a fraction of that.

[J.R. Whalen]

If the stock pops and then comes back down and may go over a certain threshold and causes the note to be called, then all of a sudden you're out of the stock.

[Ben Isen]

Exactly. The note is called and you basically earn a fraction of that yield. What we've found is that a lot of these notes, well, they deliver a lot smaller returns than the stock itself. And oftentimes because these products are packaged together with derivatives and bank debt, banks charge somewhat hefty fees. And sometimes these fees, or oftentimes these fees are higher than the actual returns that an investor gets because the note's outstanding for such a short amount of time.

[J.R. Whalen]

And we've seen a pullback in tech stocks in the recent past and that's allowed some of these notes a chance to breathe and not be called as frequently as they might have in previous months.

[Ben Isen]

If you think about Facebook, it's taken a couple of big dives this year and one somewhat recently. You've seen some of these notes tied to Facebook end up being they continue to exist for longer than they might if they were tied to Amazon, which has been on a straight line up because of that. Those notes get called at the earliest possible time.

[J.R. Whalen]

One investor you spoke with said he'd rather buy these auto callable products for a major index like the S&P 500 and not for an individual stock.

[Ben Isen]

Right. His view was that the S and P is a little bit less volatile than an individual stock and he sort of have a better sense of how the note is going to perform. Of course, the note can also get called. The S and P has been going up as well, recently hit record highs. That's not out of the question. But in that sense here it's a little bit more of a known quantity.

[J.R. Whalen]

A company like Facebook, you could see some gyrations in the stock based on the company performance and things associated with the company. But because the index is more diversified, it might be a small smoother ride up and down that could hold those notes in check.

[Ben Isen]

And I think it's important to note that oftentimes these notes do have a risk of principal loss. So oftentimes the way that they are designed is if the underlying entity falls 25% or 30% or something like that at maturity, you end up taking losses on par with the underlying. So it's a little bit more likely that a single stock will fall by that much than a big index which is more diversified.

[J.R. Whalen]

Okay. That is Wall Street Journal markets reporter Ben Isen joining us here in our studio. Ben, thanks for being with us.

[Ben Isen]

Thank you.

[J.R. Whalen]

And that's your money briefing. I'm JR Whalen in New York for

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