Can Structured Note ETFs Help Retirees Sleep at Night?

The term structured note ETFs may sound like technical Wall Street gibberish, but this investment product could be just the ticket for retirees, who want portfolio growth but are wary of market corrections. 

The products are somewhat new and package a complex strategy in a familiar wrapper, which is meant to provide investors with growth and guardrails. Structured notes can be designed to ensure an investor loses no more than 10%, no matter how far a particular market index falls, for example. The other side of that coin is typically a ceiling: Participation in market appreciation is also often capped, sometimes at 15%.“They can solve a whole bunch of problems for investors,” said Zachary Evens, a manager research analyst at research firm Morningstar, citing issues like income and downside exposure. “You will know in which scenarios you will make money, in which scenarios you will lose money, and in which scenarios you will get income or not get income.”

Structured note ETFs have gained traction over the past several years as part of a trend to satisfy investors’ demand for safe returns. They’re part of Morningstar’s “defined outcome” ETF category, which includes 420 funds and $78 billion of assets. The products have three main building blocks: an underlying exposure to a benchmark like the S&P 500 or Nasdaq 100 indexes (or even to Bitcoin); a package of options or other hedging instruments; and an ETF wrapper that adds management fees, daily pricing and exchange trading so investors can buy and sell shares like they would stocks.

Structured Post-it Notes

Institutions and wealthy families have long bought bespoke structured notes through brokers or bankers, filling out paperwork to do so, often investing $100,000 or more, and getting investment products tailored to their situations. The ETF wrapper brings structured notes within reach of retail, mom-and-pop investors. As off-the-shelf products, structured notes aren’t customizable, but they cost a fraction of traditional structured notes, not to mention having superior liquidity. They can also be bought and sold anytime on an exchange.

Structured notes solve two problems for current and near-retirees. Younger people can afford to invest aggressively because if they lose a big chunk of their principal, they have time to make up for it through long-term market gains and their work income. Older investors don’t have either luxury, especially if they need to stretch their nest egg for many years. Instead, they need ongoing growth, but they can’t afford high levels of risk. Enter structured notes and the ability to sleep soundly.

Make no mistake though, structured note ETFs carry a tradeoff. Issued by companies like BlackRock, Innovator Capital Management (recently acquired by Goldman Sachs), First Trust and Calamos Investments, they’re cheap compared with traditional structured notes. But they’re much more expensive than other kinds of funds. And you can still lose money if the market falls steeply. Like stocks, the products can be traded for free through discount brokerages like Schwab or Fidelity. But their ongoing management fees range from 0.5% to 1% of assets per year. An S&P 500 ETF, for comparison, might cost as little as 0.02%. On a $10,000 structured note ETF, you’d pay about $50 to $100 per year in fees, versus as little as $2 per year in fees for that S&P ETF.​

Those upside caps can be costly as well, said Evens. “If you’re a long-term investor, capping upside can introduce significant opportunity costs because the best market years, and even the best market days, account for a large proportion of long-term returns,” he explained. “So if you cap those returns, you’re potentially missing out on some significant gains.”

On a Side Note

While structured note ETFs aren’t customizable, they do come in different flavors. Buffer ETFs spell out how much downside investors are shielded from and how much upside they can keep over a specific period, typically a year. A buffer absorbs the first chunk of losses, say 10% to 20%, in exchange for capping gains if the underlying index rallies. Barrier income ETFs are designed to pay attractive monthly or quarterly income. If the benchmark stays above a certain price barrier, your income continues. However, if it falls too far, your income may stop and your share price can drop.​ More exotic products include dual-direction ETFs, which are meant to deliver positive returns in modest up or down markets.​

Remember that timing matters when buying structured note ETFs. To get the advertised buffer, cap or protection, investors generally need to buy the fund near the start of the time window its strategy targets, called an outcome period, and hold it until it ends. Buying too late could mean part of the buffer or upside is already used up. Structured note ETFs publish start and end dates for their outcome periods online or on apps: Some companies roll out a new vintage each month so eager investors don’t have to wait long. Once an outcome period ends, the funds reset by entering a new set of options or other hedging instruments for the next one-year period. Investors can hold shares through multiple years. 

Note to Self. How much of one’s portfolio should structured note ETFs take up? There isn’t a one-size-fits all solution because clients’ risk tolerance, income needs, ages and more vary. But concentrating too much of any asset type in a portfolio is risky. For some clients, knowing that even a modest portion of their retirement savings is invested with guardrails can create the confidence to invest the rest more aggressively. 

When kicking the tires on structured note ETFs, be sure to fully understand the costs and the cap rates, and where they might fit in your portfolio. The variables can add up quickly, so understanding the full risks and rewards of these funds is paramount. “These products are still complicated,” said Evens.