This is the fourth article in our Wall Street Fugazi series highlighting the dangers that Wall Street products can hold for retail investors. [Read the full framework for protecting yourself from Wall Street’s sales culture.]
Fugazi alternative investment pitches rely on financial romance and implied status to cover up mediocre after-tax performance. But it gets worse: sometimes a Wall Street fugazi combines hype with intentional obscurity to cloak costs and risks that combine to produce terrible expected performance.
Structured notes are pre-packaged investments manufactured by investment banks to combine a traditional security (like a corporate bond) with complex derivative payoffs (such as options contracts). Not all structured notes are fugazi, but Wall Street loves them and similar products because they carry high fee margins and are nearly impossible for retail clients to accurately value. Which makes them fugazi-prone.
Consider a specific regulatory filing from one of the largest investment banks in the world hyping a structured note using one of the highest-profile new public companies, SpaceX.
Morgan Stanley’s Enhanced Trigger Jump SpaceX Securities: The pitch versus the reality
This product’s name oozes excitement: Enhanced Trigger Jump SpaceX Securities. It leverages the allure of an iconic young company that is literally going to the moon and signals privileged, “enhanced” access to high-yield upside.
Let’s use an SEC filing to analyze the economic reality (the pitch lines quote the filing):
This product’s name oozes excitement: Enhanced Trigger Jump SpaceX Securities. It leverages the allure of an iconic young company that is literally going to the moon and signals privileged, “enhanced” access to high-yield upside.
Let’s use an SEC filing to analyze the economic reality (the pitch lines quote the filing):
1. The fugazi implies: “Guaranteed Security with Upside”
- Pitch line #1: “Based on the Performance of the Class A Common Stock of Space Exploration Technologies Corp.”
- The reality: Investors are likely to infer that they will make more money as SpaceX stock goes up. Like any good misdirection, there is a kernel of truth here. Investors do make money if SpaceX stock goes up, but they do not make more money as SpaceX stock rises. More importantly, they can lose all of their money if SpaceX stock goes down enough.
- Pitch line #2: “Fully and Unconditionally Guaranteed by Morgan Stanley.”
- The reality: Investors read “guaranteed” and likely assume their capital is safe. But this is not what it means. In fact, the very next line in the filing admits these are “Principal at Risk Securities.” The guarantee means Morgan Stanley promises to honor the contractual payout formula as an unsecured debt obligation – it in no way guarantees that you won’t lose your money. Further, “principal at risk securities” doesn’t clearly communicate the fact that you could lose all of your money.
2. Structured notes generally have terrible asymmetric payoffs
- The price: $1,000 per security for an 18-month term.
- Capped upside: If the Class A common stock of Space Exploration Technologies Corp. (SpaceX) remains flat, rises, or even falls by up to 50%, you receive $1,401.30 at maturity. Downside protection! A 40.13% return over 18 months even if SpaceX stock falls 50%!! This, which at this point feels pretty much guaranteed, sounds amazing, right? Let’s look deeper.
- The downside cliff: The note’s downside protection is anchored to a catastrophic cliff trigger. Which means it is in a real sense an illusion. The moment SpaceX stock drops by more than 50%, the note’s downside buffer vanishes completely and noteholders absorb full loss from initial value:
- If SpaceX drops 50.1%, $1,000 becomes $499.
- If SpaceX drops 60%, $1,000 becomes $400.
- If SpaceX drops 100%, $1,000 becomes zero.
The structured notes are fully exposed to large drops in SpaceX’s stock price, all the way down to zero. To put this risk in perspective, shortly after its IPO, SpaceX spiked to a high of $225.64 (June 16th) before closing the day at $201.80. Fifty days later, the stock hit a low of $104.83 (August 5th) before rebounding to close at $108.27.
That is, SpaceX’s stock price dropped 46.4% over those 50 days. A 50%+ stock price drop is well within newly public tech unicorns’ historical volatility. The risk of losing most of your investment in this kind of structured note is very real.
Investors are taking on the catastrophic tail-risk of a single speculative stock crashing, while their upside is capped at 40.13%. If SpaceX doubles, triples, or quadruples over those 18 months, the structured note never pays more than 40.13%. But if it drops sharply, structured note investors bear the full downside.
A more honest title for this note would be “Capped-Return Trigger-Crash Downside Assumption Securities.” Instead, investors are left free to interpret the notes as high yield with downside protection. Which is true, albeit in a not very useful way. The economic reality is that investors act as poorly-paid insurance underwriters for Wall Street, absorbing the bank’s downside equity tail risk while accepting a hard ceiling on their own upside. The fugazi is never what it first appears to be.
The terrible payoff asymmetry for investors is, of course, a great payoff asymmetry for Morgan Stanley. And not only are Enhanced Yield Jump Trigger SpaceX Securities high risk for investors, despite the 40% headline yield, they are also low expected return.
3. Structured notes are often overpriced
The most telling detail supporting why this is a terrible deal for investors is on the very first page of the bank’s regulatory disclosure. Morgan Stanley explicitly states that while they are selling these securities to retail clients for $1,000, their own internal pricing models estimate the economic value of the note at $955.60. They are selling investors a note worth less than $956 for $1000. Individual investors are being sold overpriced, illiquid, asymmetric contracts that virtually no sophisticated institutional trader would ever touch.
SpaceX, the company, isn’t a fugazi. Structured notes are not necessarily fugazi. Morgan Stanley’s Enhanced Trigger Jump SpaceX Securities are a model of Wall Street fugazi.
For example, suppose hypothetically that the general economics of structured notes, capped upside with meaningful but limited downside protection, is a good fit for your portfolio. Instead of a proprietary, complicated structured note, a fiduciary advisor might direct you to defined-outcome ETFs, also known as buffer funds.
These ETFs offer the same kind of payoff but with significant advantages:
- Lower cost with transparent pricing. Morgan Stanley’s Enhanced Trigger Jump SpaceX Securities being sold at an 8.5% premium to estimated market value disguises the cost: a 4.65% spread over the 18-month life is over 3% per year. Defined outcome ETFs clearly disclose their costs, typically 0.5%-0.85% annually.
- Liquidity with market pricing. Investors have to hold their SpaceX trigger notes for 18 months and have no visibility into what they are worth during that time. ETFs are traded like stocks, so investors can observe market prices and buy/sell at any time.
- Tax efficiency. If SpaceX notes pay their 40.13% after 18 months, it is taxed as ordinary income. ETF holders choose when to realize their capital gains, dramatically reducing expected tax drag.
The transparency embedded in defined outcome ETFs makes them less fugazi-prone than structured notes – and predictably a better deal for you.
Of course, being a better deal than Morgan Stanley’s Enhanced Trigger Jump SpaceX Securities is a very low bar! These ETFs still offer complex, asymmetric payoffs that are not suitable for most investors.
An experienced fiduciary advisor might accomplish your goals with strategies more suitable than defined-outcome ETFs – like increasing portfolio cash allocations – if these align better with your situation and goals. Regardless, what you can count on is that the advice you get will be in your best interest, which isn’t just less fugazi – it is anti-fugazi.
For the full framework for evaluating these kinds of investments and protecting yourself from Wall Street’s sales culture, read How to Protect Yourself From Wall Street’s Sales Culture.
Look Beyond the Sales Pitch
A fee-only fiduciary can help you evaluate complex investments by looking beyond the headline terms to understand the true costs, risks, and potential outcomes.
Disclaimer:
All investing involves risk, including the potential loss of principal. There is no guarantee that any investment plan or strategy will be successful. Advisory services provided by Hendershott Wealth Management, LLC (“HWM”), an investment advisor registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training.
All written content in this piece is for information purposes only and does not constitute an offer, or solicitation of an offer, or any advice, or recommendation to purchase any securities or other financial instruments–and may not be construed as such. Opinions expressed herein are solely those of HWM, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. HWM does not provide tax or legal advice.
