For many affluent clients, the drive to preserve capital is
stronger than the need for growth, so low-risk hedging strategies with some upside potential become very attractive. Pre-packaged options strategies, such as structured notes that offered principal guarantees and upside potential of an index, provided one path to relative peace of mind.
Then came the Lehman fall–and the less attractive underbelly of its popular structured notes became apparent. Investors discovered that with Lehman Brothers their principal guarantee was only as good as the firm was solid. Lehman being a credit risk was not something most people considered a significant issue before 2008. “The counterparty risk is really what caused the seismic shift in people’s interest in replicating structured notes instead of just buying them off the shelf,” recalls Robert Gordon, CEO of New York-based Twenty-First Securities, which works mostly with wealth managers, family offices of HNW individuals, and financial institutions.
“An awful lot of investors had been buying structured notes as a way to get involved in the market,” observes Gordon, who also serves on industry boards and teaches at New York University. “They wanted a seatbelt. The structured note is a piece of paper you buy that says a bank guarantees you your money back and you get some upside in the market. We suggest that clients would be a lot better off not buying the structured note, but to actually buy the pieces that make it up, such as the options themselves.”
Beyond Structured Notes
Gordon looked at the structured note to determine how to build a principal guarantee that wasn’t exposed to Lehman-like credit risk. He broke it into the two pieces. First, for example, he could buy a zero coupon bond guaranteed by the U.S. government, so the principal is guaranteed by the government, not the bank that issued the note. Second, he could buy a call option on the S&P 500 to give the solution an upside potential. The call option is listed, so it trades openly on the CBOE and is guaranteed by the Options Clearing Corp. By assembling the components, rather than buying an off-the-shelf package, the investor ends up with much better counterparties. If an advisor assembles the package, the client also saves on structured note commissions.
Taxes are another reason to assemble your own solution. With a structured note that has a principal guarantee, any payments caused by the market going up will be taxed as interest so the income tax rate applies. If an investor buys a call option on the market, any increase in value is taxed at the more attractive capital gains rate (attractive at the time of this writing, at least). This approach to using options directly is also more transparent, notes Gordon. “You can pick up the newspaper and see what the price is, versus being dependent on your end-of-the-month statement and the dealer assigning a theoretical value for a structured note,” he says. “The zero coupon bond and the listed option are publicly traded, so they will always have a posted price. For all of these reasons, we tell people that they if they like structured notes, build them themselves.These payoff patterns are a safer way to touch the hot potato.”
A Planned Return Strategy
Mitchell Eichen is a fan of this approach to using options for what he calls a “planned return” strategy. He believes that it’s a much better alternative to the structured products for his holistic wealth management firm The MDE Group, in Morristown, New Jersey, and for its clients, who are mostly active and retired senior corporate executives and high-net-worth individuals.