Question about Accelerated Return Notes and other structured products

[swimbogjl555]

Hello all - My first post on this terrific forum. I'll get to it quickly:

I have an informal relationship with an adviser at Merrill Lynch. He's a good guy and honest. I currently have one fund with him, a Small Cap Index fund. He called the other day and recommended that I might want to try a Structured Investment Product, which ML calls Market-Linked Investments. He gave me three possible such products: an Accelerated Return Note (aka ARN), a Capital Leveraged Index (aka CLERN), and Strategic Accelerated Redemption Security (aka STAR). All three offer a capped leveraged return on the upside, and the second one offers some downside protection.

He explained how it works, and I basically understand (puts and call options sold to a third party.) Not fully, and my only hazy part is why someone would back these and take the risk of having to pay a leveraged return. I am still not 100% clear on how anyone makes a profit on this if the index goes up.

Anyway, I am considering the ARN, because it matures in 14 months, and I don't want to commit to much longer than a year. No downside protection, but if I understand correctly, the worst that can happen is that if the index is down after 14 months, I simply get that return. No different than if I simply left the investment in the index fund.

It sounds pretty good, but in reading some more about it on this forum (but the posts are rather old), and on the internet, these types of investments aren't much in fashion these days. Apparently they were pushed by ML and Bank of America at one time, but have fallen out of favor.

He told me that none of my money will be reduced by any sort of commissions, etc. So basically, 100% of my investment is in play, and anything I gain or lose is based on 100% of my investment. I asked who will be issuing this ARN, and he said that it depends, but that he has never seen an ARN go belly up or default.

Seems like a reasonable risk to take, since the worst that can happen after 14 months is that I am down by whatever I would have been down anyway. And on the upside, I could triple my gain (up to about 15%.)

One thing I will say is that he contacted me awhile back about another type of investment (can't remember what it was), and when I researched it, it turned out that it was something that had been pushed by ML a number of years ago, but that nobody does anymore.

So this seems like an ML "thing," although I have seen these structured products offered by other companies like Fidelity.

Anyway, what are your thoughts? Am I missing something, or is the only real risk on the downside?

Thanks

[retired@50]

Anyway, what are your thoughts?
Thanks

Welcome to the forum.
I wouldn't buy anything I didn't fully understand.

Some light reading...
viewtopic.php?t=99860

For more on the Boglehead way, see the wiki.
https://www.bogleheads.org/wiki/Boglehe ... philosophy

Regards,

[talzara]

I have an informal relationship with an adviser at Merrill Lynch. He's a good guy and honest.

No one who sells structured products is "a good guy and honest."

He told me that none of my money will be reduced by any sort of commissions, etc. So basically, 100% of my investment is in play, and anything I gain or lose is based on 100% of my investment. I asked who will be issuing this ARN, and he said that it depends, but that he has never seen an ARN go belly up or default.

Seems like a reasonable risk to take, since the worst that can happen after 14 months is that I am down by whatever I would have been down anyway. And on the upside, I could triple my gain (up to about 15%.)

The commissions are hidden in the returns. Typical fees on structured products are 30-50% of the expected returns.

Accelerated Return Notes hide the fees in the long tail. Any returns above 15% goes to the counterparty. If the underlying return is +25%, then the leveraged return is 75%, but you only get 15% and the counterparty gets 60%. However, you still have all the downside risk. If the underlying return is -25%, you lose all 25%. Your losses are not capped at 15%.

This asymmetric payoff is how the bank makes money. The bank is hedging the position, so it earns the options premium. The advisor gets paid a percentage of this as the commission.

Edit: There is some confusion about the AR payoff, so I'm describing the underlying return and the leveraged return.

[senex]

Anyway, what are your thoughts? Am I missing something, or is the only real risk on the downside?

From what I can tell from your description:
1. Market goes down --> same as owning index fund
2. Market goes up 0-5% in next 14 months --> you do better than index fund
3. Market goes up 5+ % in next 14 months --> you do worse than index fund

#3 is the risk. Markets are historically bursty. It might go up 50% this year, down 20% the next, flat the next. In that case, at end of year 3, your 3-year return would be -8% if you buy the structured product, and +20% if you don't. That is a huge difference.

Yes, there are other scenarios where the structured product puts you ahead. But on the aggregate in the long term, I think if you do the options math it will work out to net worse for you.

Structured Products are unpopular here for a reason.

[talzara]

From what I can tell from your description:
1. Market goes down --> same as owning index fund
2. Market goes up 0-5% in next 14 months --> you do better than index fund
3. Market goes up 5+ % in next 14 months --> you do worse than index fund

15%, not 5%.

If the underlying goes up 5%, the ARN returns 15%, which is higher.

If the underlying goes up 14%, the ARN returns 15%, which is higher. The return is capped at 15%, but 15% is higher than 14%.

This assumes that the underlying has 0% yield. Structured products usually use a price index, not a total return index, so it's worse if the underlying pays a dividend.

[swimbogjl555]

Thanks all, this is great information and I appreciate the input. I posted a response, but it looks like it never made it, so I will post it again

Taking all your points into consideration, I am thinking that with all these tariffs (even though I think he will back off on some of them), small businesses are going to suffer this year. Everything I have read says that the tariffs are hurting small businesses more than big businesses.

Bear in mind that I am only considering the 14-month instrument, and it's a one-shot deal. So at the end of the 14 months, if the Russell 2000 is up at all, I get three times the return up to 15%. If it's down, I have no protection, and I end up at the same place I would have ended up if I kept the money in the index fund. (If I don't do this ARN, I am simply going to leave the index fund alone for the next year or so.)

I am terrible at market timing, so I normally don't do it. But I am thinking that the Russell 2000 index is not going to have a great year. Last year it gained 10%. It's already down 10% this year. So I am thinking the best case is that it might gain single digits. The worst case is that it would go down. So if it gains, I get three times the return up to ~ 15%, and if it loses, it's a wash between keeping it in the index fund as is.

Obviously, if it has a banner year, I leave a lot on the table, as you have rightly pointed out. I am just not seeing signs of a banner year for small stocks. But maybe I am missing something, and please let me know if I am. I am certainly no expert on this stuff. (Which is why I am seeking advice.)

This is just a one-time thing for me at this point for the next year or so. I am not going to go whole hog on theses structured products. I am in capital preservation mode at this point, being a retiree. So I generally stick to the tried-and-true investments and instruments.

So keeping everything I said above, are you still advising against it? Thanks again, I really appreciate all the input and advice.

[senex]

I am terrible at market timing, so I normally don't do it.
...
But maybe I am missing something, and please let me know if I am. I am certainly no expert on this stuff.
...
So I generally stick to the tried-and-true investments and instruments.

It sounds like you understand you are choosing to try to time the market, despite describing yourself as "terrible" at it.

If you're wrong, you may miss out on gains.
If you're right, you may think you are good at market timing, and then continue to do things that boglehead philosophy considers behavioral errors.

If you understand that and want to do it anyway, it's your money, your choice.

[swimbogjl555]

Good point. Thanks to all of you for your input. Did some more reading as you had suggested, and I think I will stick with what I have.