Understanding Structured Derivative Products As An Investment

Structured derivative products are a type of investment that provide some downside hedges. They are also called structured notes.

I wrote this post back in 2012 after I got a six-figure severance. I was trying to figure out how to safely invest my severance with a hedge given I no longer had a job.

I'm revisiting structured derivative products today given the stock market is at an all-time high and another recession could be on the horizon. It's hard to invest in stocks at these levels while the risk-free rate is so high. Therefore, perhaps a structured derivative product may help to protect your investment from losses.

This article while share with you my experience investing in structure derivative products to protect downside and try to participate on the upside. As a family man now with a lot more wealth, protecting my wealth from loss has become more important. In other words, the older you get, the more you make shift toward capital preservation mode.

Understanding Structured Derivative Products

I'm seeking yield to further enhance my passive income streams for financial freedom (highlights the various income streams). My current CD monthly interest income is around $2,800 a month and I've got roughly $225,000 in liquid cash that's sitting in a money market account earning 0.2% interest.

Understanding Structured Derivative Products As An Investment

Having $225,000 in a money market earning 0.2% interest is a lousy $400 a YEAR, which means I can't even buy an overpriced iPad like millions of crazy rich folks are buying nowadays! The amount of money people have to spend on material things makes me so bullish about the economy. People don't spend money they don't have, just like I can't drive a Ferrari Italia that I don't own.

Everyday I keep my money in a pathetic money market is another day I'm missing out on free money. As such, I have been focused for the past couple of weeks on searching for ideal products to invest my money.

Narrowing the structured derivative products down to the following:

1) 2.3% 7-year CD with Bank of America.  Guaranteed estimated return $5,175 a year / $431 a month and bringing my CD passive income to $3,243 a month.

2) 6-10% potential returns via peer to peer / social lending. Non guaranteed $13,500-$22,500 a year / $1,125-$1,875 a month.  Have $50K ear-marked to this stream if and when the partnership comes through.  But, could invest more if things work out well.

3) Structured CDs, with a guaranteed rate of 2% for the first two years and LIBOR + 1.45%.  $4,500+ a year / $375+ a month.

4) Online trading via E-Trade or ScottTrade.  No guarantees.  + or – $40,000 a year.

5) Private equity investments. I've received a couple offers to invest in some start-ups in the Bay Area. 70% chance for a -100%, up to a 5-10% chance for a 500% return.

6) Rental property. Borrow at 3%, earn a rental yield of 8%. Estimated cash on cash return is 5% therefore $10,000 a year / $833 a month.  Return on principal based on potential appreciation is different. Problem with rental property is that it is a PITA compared to online income or CDs. That said, you should never sell your rental property if you don’t have to. Let Insulation push up renting property prices overtime.

7) Structured Notes. Similar to Structured CDs, but not FDIC guaranteed, and different return profile.

Not too narrow a list huh? The goal is to raise the $6,500 gross a month passive income to around $15,000 a month in order to have a comfortable lifestyle enough to take care of a family of four. The other goal is to have money work for me so I can focus on my business.  The strictly passive income goal (excludes online and all other income) may change over time, but for now, $15,000 a month is what I'm shooting for.

If possible, please don't get distracted by the capital amount discussed and if it helps, use whatever capital amount that makes you feel comfortable.  The discussion focus should be on understanding structured products and feedback on a couple choices below.

THE FOCUS ON STRUCTURED PRODUCTS AS AN INVESTMENT OPTION

I like the dumbbell approach to investing e.g. high risk + low risk. As I looked more into Structured CDs, I've come to realize that structured CDs are exactly what I like!  Structured CDs guarantee a minimum rate and up to $250,000 of your money back thanks to the FDIC insurance + it has an upside component to its returns based on a derivative.

Structured CD Examples:

1) A 5-year CD rate will guarantee you a 1% minimum return every year for 5-years.  However, if Mitt Romney wins the 2012 Presidential election, the bank issuing the structured CD will agree to pay you 10% a year for the remaining four years!

2) A 3-year CD will guarantee you a 0.5% return for year one, a 3% return in year two, and 4% return in year three if the S&P 500 increases by 15% in year two, and at least 10% in year three.  Every percent beyond 15% and 10% in years two and three will be divided 50/50 eg year two has a 19% increase, hence your 3% return gets a 2% bonus.

3) A 7 year CD will guarantee you 2% the first year, and 3.5% every year for the remaining six years so long as the CPI (inflation) index stays below 3.5%.  Every 0.1% increase above CPI reduces your 3.5% rate by a commensurate 0.1% with a 2% floor.

So excited to start investing in structured CDs until I went looking for them.

I strolled over to Citibank to ask about their latest structured CD offering and to my surprise, they don't have any! Disappointed, I asked what else they've got. Structured Notes of course! 

Structured notes are investment products that are structured by the bank for their wealth management clients. The products have Initial Public Offerings and are NOT guaranteed by the FDIC.  Instead, the guarantee, if any is based on the viability of the institution and the markets.

There are a myriad of Structured Note products, and I want to focus on two that sound most interesting and ones where I am actually considering putting capital to work:

Dow Jones Principal Protection Structured Note

* Minimum investment $50,000.

* 6 year note to maturity.

* Receive 0.5% coupon per year for 6 years.

* Receive 100-110% of the upside of the Dow Jones Industrial average from day of structure (May 24, 2012 in this case). In other words, if I invest $225,000 and the DJIA is up by 20% in 6 years, I will have made a $45,000 return + 0.5% in annual interest income for the duration.

* At the end of 6 years, I get 100% of your principal back at a minimum.  If we go into a horrible bear market and the DJIA goes down 30% in this time period, I get all my money back provided the market is still functional.

* Opportunity cost is 2.3% CD – 0.5% coupon = 1.8% per anum I do not invest in the 2.3% BoA 7-year CD = $300/month or $3,600 a year.

* The return on the DJIA payment is a “bullet” at the end of 6 years.  In other words, all proceeds are paid at once upon maturity.

S&P 500 Buffered PLUS Structured Note

* Minimum investment $50,000.

* 2 year note to maturity.

* Receive 0% coupon over 2 years.

* Receive a 10% downside buffer based on day of offering (June 4, 2012). In other words, if after two years the S&P 500 is down 12%, I only lose 2%.

* Receive 2X the upside of the S&P 500 in two years up to 18-22%.  In other words, if the S&P 500 is up 5% in year 1, my return is 10%.  However, if the S&P 500 is up 30% in two years, I don't get 60%, but a max 22%.

* Opportunity cost is 2.3% a year to -92.3% of the value of my principal if the S&P 500 goes down by 100%, which is not going to happen.  Also not allowed to receive the 2% annual dividend yield the S&P 500 is currently providing.

WHICH STRUCTURED NOTE WOULD YOU CHOOSE?

I like the S&P 500 Buffered PLUS note because there's only a two year lock-up and has a nice 10% downside protection before I start losing money.  My bogie for market returns a year is 3X the 10-year bond yield =  ~6% at the moment. 

If I can get 2X that return, that yields 12%, which is on par to earn a max two-year return of 18-22%.  Although my bogie is 3X the risk free rate, I'm really always shooting for a 10% per anum return.

The Dow Jones structured note is also attractive because it proves a 0.5% coupon while I wait, returns all my money at the end of 6 years even if the markets go down, and gives me 100%-110% of the upside. 

I'm a long-term investor, and if I can find a product that I like, the longer to maturity the better!  The downside is if I do need to tap the $225,000 in capital, I would have to sell the note at a loss. There are no penalties, just the market rate for the note, as a large value of the note is time.

BEFORE YOU INVEST IN STRUCTURED PRODUCTS

* Understand yourself. You need to first understand your risk tolerance, income generating abilities, and capital needs.  My preliminary requirements are that I want a minimum guarantee return of all my money back (principal protection), with a minimum 30% optionality of up to 15% on the upside, for as long a duration as possible. 

Doing the math, If I can get a risk adjusted total expected return on my structured product of anywhere between 4-10%, I am a very happy camper because I expect inflation to be well contained.

* Understand the product. Make sure you have the banker explain everything in as much detail as possible.  Ask for the downside risk and upside risk.  Ask them to provide you examples of various return scenarios.  Make sure you understand everything before you lock or invest your money away.  Spend time reading the entire prospectus for structured notes!

* Focus on big institutions.  I'm sticking with the big banks like Citibank, Bank of America, Wells Fargo, USAA, and Chase because: 1) They are too big to fail, and 2) I already bank with many of them, hence have more leverage.  These aren't fly by night banks, so I feel confident they will be around, or be bailed out by the government if they get in trouble.

* Everything is negotiable.  Don't take everything at face value.  Ask for a better rate, or a better product.  There is always something for everybody.  I suggest you come in with as large a war chest as possible, but keep the amount hidden.  The more money you have, the better concessions they will give you. 

They will always ask how much you are thinking of investing.  Start with their minimum… perhaps $10,000, and work your way up by asking with each increment what more you can get in return.  When you anchor low with $10,000, and start speaking about $100,000 at the end of the conversation, the bankers will really start bending over backwards for you.

* Get motivated to earn more money.  The banker's minimum investment to open a structured product investment is $50,000 if I invest $100,000.  Clearly the banker has incentive to bring in as much money as possible to earn a commission (1-3% of principal).  

The point is, these products will only be offered to a minority of people because the banker only has so much time and is not going to open 100, $1,000 accounts when he can open 1, $100,000 account.  Having a cash hoard gives you optionality to invest in potentially superior investment returns.

Update: I ended up investing $150,000 in the DJIA structured note and $75,000 in the S&P500 structured note $225,000 in June, 2012. I would not have invested as much in the markets if there wasn't a downside protection component. The structured notes ended up doing very well.

Looking back, now that it’s 2024, I wish I was greedier with my investments. Instead of buying a structured derivative product for Dante production, I should’ve just bought Apple, Google, and Facebook stock. If I did, I would be at least $1 million richer today!

Invest In Real Estate

Today, I'm more interested in investing in real estate over stocks at the moment. Prices are down because mortgage rates are way up. Therefore, you have less demand and can find more deals.

If you're interested in a hands off approach to real estate investing, take a look at real estate crowdfunding. Once I had my son in 2017, I decided to sell my PITA rental house and reinvest $550,000 of the proceeds into real estate crowdfunding. My favorite two real estate crowdfunding platforms are:

Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private funds. Fundrise has been around since 2012 and is a great way to diversify your investments. The company manages over $3.3 billion in assets and has over 500,000 investors.

CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends.

Both platforms are sponsors and Financial Samurai is a six-figure investor in Fundrise. 

Invest In Private Growth Companies

In addition, consider investing in private growth companies through a fund. Companies are staying private for longer, as a result, more gains are accruing to private company investors. Finding the next Google or Apple before going public can be a life-changing investment.

One of the most interesting funds I'm allocating new capital toward is the Fundrise venture product. Fundride invests in:

  • Artificial Intelligence & Machine Learning
  • Modern Data Infrastructure
  • Development Operations (DevOps)
  • Financial Technology (FinTech)
  • Real Estate & Property Technology (PropTech)

Roughly 75% of the Innovation Fund is invested in artificial intelligence, which I'm extremely bullish about. In 20 years, I don't want my kids wondering why I didn't invest in AI or work in AI!

The investment minimum is also only $10. Most venture capital funds have a $250,000+ minimum. In addition, you can see what Fundrise is holding before deciding to invest and how much.

Traditional venture capital funds require capital commitment first and then hope the general partners will find great investments. It's almost like investment arbitrage.

You can listen to my hour-long conversation with Ben Miller, CEO of Fundrise, about AI, investing in private growth companies, and the future.

Track Your Net Worth Easily For Free

The best thing to grow your wealth is stay on top of your finances by signing up with Empower. They are a free online platform which aggregates all your financial accounts in one place so you can see where to optimize.

Before Empower I had to log into eight different systems to track 28 different accounts (brokerage, multiple banks, 401K, etc) to track my finances. Now I can just log into Empower to see how my stock accounts are doing, how my net worth is progressing, and where my spending is going.

Their 401K Fee Analyzer tool is saving me over $1,000 a year in fees I had no idea I was paying.

They've also got an incredible Retirement Planning Calculator they launched in late 2015 that uses your real income and expenses inputted to give you an idea of your retirement future. There is no better free platform out there that is helping me manage my money. The entire sign-up process takes less than a minute and is free.

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Empower's Retirement Planning Calculator. Click to see how you're doing

About the Author:

Sam began investing his own money ever since he opened a Charles Schwab brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered.

In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $350,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.

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Hue Than
Hue Than
5 months ago

This is incredible information, thank you millions for your kindness.

Alan
Alan
3 years ago

For your cash, try Tmobile checking. It may only pay 1% but that sure beats .2%!

Charlie
Charlie
7 years ago

Hi,
How did your Structured Notes do? I’m guessing the DJ one is still growing.
Did you re-up with the S&P product? Lastly, any similar risk/reward products new to the market that interest you?
Regards,
-Charlie

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[…] But in a way, I have been creating my own equity hedged portfolio with my accumulation of structured products since 2012. Give me 5-8% returns every year with low volatility, and I’ll happily invest all […]

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[…] home runs. I’ve structured my after-tax investments to be more low-risk through structured notes, and my pre-tax investments in my rollover IRA, SEP IRA, and Solo 401k to be more high risk. Given […]

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[…] any financial windfall. By the summer of 2012, the market had taken a little dive and I finally invested the entire amount in the stock market so as to make it disappear. I wanted to stay hungry and pretend I received […]

Anonymous Student
Anonymous Student
12 years ago

These seem like pretty lucrative products Sam! I was suspicious after looking at the word “structured”, because it got me thinking about CDOs and structured tranches of bad mortgages – but these don’t look to shabby!

Still – what’s the incentive for the person on the other side of the deal for this proposition? I understand part of it is the high capital buy in compared to other investments, but it seems to me that whoever is on the other side of the deal seems to believe they can beat the S&P or the DJIA index with the money you’re handing them?

AWJ
AWJ
12 years ago

The S&P 500 Buffered PLUS Structured Note interests me, but my broker is Schwab and they have no idea how to acquire the S&P 500 structured note you mentioned. How do I go about purchasing these structured products?

Thanks.

AWJ
AWJ
12 years ago
Reply to  AWJ

Wait – scratch that. They called me back with some info. Hopefully, I can get into one of these soon.

Dan23
Dan23
12 years ago

Is the DOW product 100% of final value or 100% of some average 7 year value?

Invest It Wisely
12 years ago

Interesting, learned something new about structured notes. These are out of my price league for now but could be interesting down the road.

Eric
Eric
12 years ago

I take it on these structured notes that returns on the DJIA or SP500 are price only and do not include dividends? Does that still pencil out? Also, do these pencil out if your time horizon is much longer than 2 or 6 years? Missing out on upside potential can be very costly if you have the time horizon to wait out any correction that happens over that time period making the protection on downside only a psychological benefit. Curious to hear your thoughts.

kartik
kartik
12 years ago

Have you considered Fixed Deposits in a Foreign Country, particularly India? A lot of banks with operations in India (eg. SBI, IDBI, Kotak Mahindra etc) are currently giving a 9-10% interest rate on deposits made in Indian Rupee. (The interest is tax-free in India and obviously taxable in USA)

That is a guaranteed investment return. The only downside risk that you have is the currency fluctuations between the USD and the INR.

BusyExecutiveMoneyBlog
BusyExecutiveMoneyBlog
12 years ago

I really like this post and conversation. Lot’s to learn here. The real question is where rates are going? Is there a strong liklihood that Ben will have to raise rates after 2014. If so, then you could potentially be back in the 4%+ range on CD’s by then. The structured stuff is new to me but sounds a lot like point spread betting (with some gaurantee’s of course). I’m focused on building the “nut” today and constructing a cd ladder once rates are respectable again. So, capital preservation is key.

Nunzio Bruno
Nunzio Bruno
12 years ago

Hmmm this one was a stumper for me. What I would do is probably stay out of structured debt all together. I like the property idea and would definitely consider it. I might also get a little active with management and create a portfolio. If I were in your situation while I would a fix a percentage of it to good quality credit I think I would do a percentage of solid value and dividend plays then get aggressive with with about 20% – like trying to nab some FB IPO action. Over 5-6 yrs I think you’ll have better luck earning a return out in the market with a diversified portfolio in the market then parked in structured debt instruments.

Nunzio Bruno
Nunzio Bruno
12 years ago

Right right! Sorry I mispoke (mis-wrote) I was trying to refer to the three options you liste :) You are definitely right on the stress to the FB IPO.

traineeinvestor
12 years ago

If the goal is to provide passive income now/in the short term, then neither structured product would appear to meet your needs – one offers no yield and the other a paltry 0.5%.

If the goal is to boost your passive income in two/six years time (without caring about yield before then), and it was a choice between the 2.3% CD, the 6 year Note and the 2 year Note, my vote would be for the two year Note. There’s no such thing as a free lunch but leverage on the upside combined with the downside buffer is a pretty compelling risk reward ratio. I’d probably go in with the intention that if the market was down on maturity and I had no better ideas, I’d roll the money into an S&P index fund. Effectively, I’d be telling myself if the markets are up in two years time, then I beat the market. If the market’s down, then I’ll buy at a discount to today’s prices.

I don’t find the six year that attractive. Firstly, six years is a long time for most of us and a lot of things can happen in that time – marriage, children, illness, divorce and a visit from the four horsemen – which require needing the money early. Second (and you need to check the fine print on the contract), you are betting not so much on what the market does over six years but in where it will be on a specific date in six years time (or possibly some average for a few days at around that time). You could end up trading a lot of opportunities to make money and taking on the possible risk of seeing your investment mature in the depths of the next financial crisis.

As a side question, have you run the numbers on creating your own structured product using a combination of CDs/short term bonds and options?

Hiro
Hiro
12 years ago

Thank you very much for another meaningful post.

Like you, I’m not sure what to do with the cash at the moment. I’m having about 200k extra cash sitting in my HSBC. Thinking about to pay off some of the mortgage(currently 3.75% 15 yrs fixed in Houston). Really like the idea of rental properties but need to do more research. If you have any basic info about rental properties please send it over. Many thanks in advance.

The good thing about having cash at the moment, especiallly when I am somewhat bearish economy, is that I can get into the market whenever I like. I understand there is some opportunity cost but I value the liquidity at the moment. What do you think about my point of view?

Hiro
Hiro
12 years ago

sorry, i hit the enter button before reply back to your question.

I like the 2 yr structured note option just simply it’s a shorter term product
with a limited down size. The note actually sounds like a strangle to me,
which isn’t a bad position to have at the moment.

retirebyforty
12 years ago

Thanks for the post on structured notes. I don’t know anything about this product. I should talk to Chase and see what they can offer me. Keep us updated on which way you’ll go.

Investor Junkie
12 years ago

If with P2P you already have allocated $50k, then why even mention it? I agree you made this post way too complicated. You also are missing many other types of investments in the “fixed” income area, especially since this is taxable investments.

Why not?
– Munis?
– MLPs?
– High Yield?
– Dividend Stocks?

Granted all are not “guaranteed” fixed income but you are already passed that based upon your investments selections mentioned.

Investor Junkie
12 years ago

With my $10k in P2P I’m having an issue of finding notes that meet my very selective criteria.

Investor Junkie
12 years ago

Munis and High Yield have a chance to lose money? Only if the FED rate rises and you’ve stated you aren’t concerned about that. The others yes.

Investor Junkie
12 years ago

No, obviously there are many other factors, but if you choose your bonds right do you really think there is much downside risk (ie greater than 10% like you stated)? The biggest risk would be the FED rate, hence why I mentioned just that.

In addition with the amount of money you are talking about you could easily have a greatly diversified portfolio, get a high blended rate. So even if one default or turned on you you should be fine. So it still goes back to the biggest risk, the FED funds rate.

Investor Junkie
12 years ago

Why does it have to be all or nothing with the selection? Why not some in structured notes, and say P2P lending?

Investor Junkie
12 years ago

Sorry, I don’t have any experience with them. It’s about the only investment I don’t have experience in. They never really have appealed to me.

San Diego
San Diego
12 years ago

Sam call me crazy but I think your best long term investment would be to buy land with good water and start a farm. You could create a fully sustainable lifestyle for yourself and achieve true economic freedom. It would be wise to start a variety of businesses on the property such as a winnery, a flower/vegetable garden and a fruit orchard as these activities would provide a diversified revenue stream. I see land and water being 2 limited resources that are going to dramatically increase in value in the next 15 to 30 years. Also food, especially organic food is going to be increasing expensive to buy as the cost of water and land increases. And if shit really hits the fan then you have food and water available. You can’t eat greenbacks or gold bars, these types of materials are only valualbe because we collectively believe they are valuable. Just my $0.02

San Diego
San Diego
12 years ago

Thanks for keeping an open mind Sam. I would recomend any state that you feel comfortable living in and is conducive to farming, most states are adequate for farming depending on what your interests are. California and Hawaii would be great locations but land can be quite expensive. However, there is a great video about living in Hawaii mortgage free that I highly encourage you to watch (this is not spam), it may be a big lifestyle change to live in a tiny home but I think such a life has its appeals and charms…

https://www.youtube.com/watch?v=wxGr9uloL9k

Im curious if you could see yourself in a similar situation.

San Diego
San Diego
12 years ago
Reply to  San Diego

Go for it Sam! Move to Hawaii if that makes sense to you and you see yourself being happy there, I would if I was in a similar situation! Life is truely what you make of it. Im only 29 so I still have quite a few more years until I can hang up my corporate monkey suit and trade it for some overalls. Oh by the way if you are ever in SD let me know, my girlfriend and I would love to take you to dinner in La Jolla, we have excellent Sushi here, you got my email…

San Diego
San Diego
12 years ago
Reply to  San Diego

Yeah La Valencia is awesome! Especially lunch on the terrace with its ocean view, highly recomend the cuban sandwhich. You are probably thinking of the Mexican restaurant Jose’s, its a popular one. I like your idea about grinding it out until 35 and re-evaluating at that point. Seriously Sam look me up next time you are in SD!

-Joe

Untemplater
12 years ago

I am guilty of having all of my savings from last year in a pathetic money market account. I normally use CDs but just didnt bother last year bc the rates were so low. I’m glad I read this post because I hadn’t heard of structured CDs or structured notes before.

The 2 structured notes you found sound pretty good. That’s too bad they aren’t FDIC insured but they have good built in protection. I’m a low risk investor so I’d probably put my money into both of them as long as I didn’t have to pay fees to do both.

I like your advice on anchoring low too when going to talk with a broker. I would probably give up too much info too soon if I hadn’t read that!