Structured Notes vs. ETFs

Roger Nusbaum has a post on ETF Investor (mirrored on his blog) about retail structured products. I’ve written about SPs in the past (e.g., here and here) and wanted to comment further.

My two biggest objections to SPs, especially those marketed to retail investors, are that (1) they are typically far from transparent, and (2) they are usually very expensive.

Let me illustrate these two points by picking on a single security, the Citigroup Global Markets Principal Protected Notes 1% S&P 500 Index due 1/28/2010 (PSC; prospectus). If you look at the prospectus, what this note is basically offering is five years of exposure to the S&P 500 with an embedded put option to limit downside risk. For every $10 note you buy, you are guaranteed to get back at least your original $10 plus interest. You also might get back something extra if the average performance of the S&P 500 exceeds a certain threshold over that period.

That all sounds appealing, but the devil is in the details, and that’s precisely my point about transparency. For instance, the question of whether you get the S&P 500 equity kicker payment in 2010 depends on a complicated formula involving the monthly closing level of the S&P, not its absolute level at the maturity date of the note. This makes it very hard to understand what you are buying. The underwriter for an instrument like this, and therefore your broker, will usually provide you with a table of hypotheticals showing under what scenarios you would get the equity kicker, but this table is (obviously) designed to paint the structured product in the best possible light, since your broker only gets paid if you buy the damn thing. (Exception: “fee-only