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Structured notes are debt securities that are generally manufactured and distributed by banks and have been available to mainly institutional investors in the US since the late 1990s. Considered alternative investments, they are hybrid instruments that combine a bond component with an embedded derivative component that adjusts the security’s risk-return profile and provides asset managers with a richness of investment and portfolio construction options.
Structured notes are linked to a reference asset, the most common being equities but they can also cover various indices, interest rates, and currency, commodity, or property markets, as a few examples. The payoff and level of capital at risk can be pre-defined and can be designed to take advantage of rising, falling, or range-bound markets, and delivered in a way that can be tailored to the needs of investors. They are typically categorized as either growth or income subject to the payout profile and typically include a degree of downside protection. The performance of a structured note will track both the underlying debt obligation and the derivative embedded within it.
The wide-ranging structured notes marketplace represents approximately 25,000-30,000 unique notes and $130B in sales annually that are distributed through broker/dealers, independent financial firms, family offices, and RIAs. SRP (Structured Retail Products) is a comprehensive source for further information on structured products data, market intelligence, and education covering over 40 million products across the global structured products industry.
To better understand structured products and how to deploy them for portfolio investment and risk management, we were introduced to Gregory H. Sachs, CEO and Chief Investment Officer and Todd Dilatush, Head of Distribution of SCG Asset Management – an investment advisory firm collaborating with institutions and strategic partnerships on bespoke or turnkey structured products solutions and the investment manager of the Alternative Strategies Income Fund (LTAFX - LTIFX) which is the first-of-its-kind continuously offered, closed-end interval fund focused on income-oriented structured notes. The fund offers a unique equity derivative income strategy utilizing an actively managed structured note portfolio providing access to these investments with lower minimums and no accreditation requirements or K-1 tax forms. We asked them questions about structured investment notes and The Alternative Strategies Income Fund.
Hortz: How did you originally get involved with structured products and what attracted your interest in them?
Sachs: What I always liked about structured notes is that every note in and of itself is one that we can create – it is not one we buy off a shelf – so we can deliberately design its structure to have a relatively low risk of losing money. Now I use the word relatively because it's certainly not zero. However, I can choose embedded assets where I understand the idiosyncratic risks of the reference asset and our average weighted coupon has always been above 20% and sometimes above 25%.
Dilatush: I first became involved in structured products while at Barclays which had an established structured product presence. In 2004 with the buildout of a New York based team, I was presented with an opportunity to join the initiative from within the organization at inception.
In those early days, there was a tremendous lift in bringing an unfamiliar and complex product set to the U.S. broker/dealer market. What made structured products most interesting to me was the ability to be creative and problem solve while designing and presenting structured notes in a sales role. Each product is unique and to be able to construct bespoke solutions working in conjunction with advisors and institutional asset managers to create tailored payout profiles seemed to be a perfect fit.
Hortz: Can you share with us your perspective on the structured products marketplace right now? What should advisors and investors know about these investment instruments?
Sachs: The structured note market is growing significantly and with great variety. So much so that it is very important that advisors and the end investor really understands the note that they are purchasing and the risks associated with it, as structured notes are not standard. Each note is unique and purchased individually with different embedded parameters and associated risks. With conditional income-generating structured notes, there are different payout profiles and a plethora of reference assets to choose from subject to an investor’s risk profile.
There is no shortage of structured note options available to advisors today. The challenge advisors face not only lies in the note selection process, but also with the operational resources required to effectively manage multiple notes purchased over time. I personally think that having a diversified portfolio of structured notes that are quantitatively put together and actively managed by a fiduciary is a lot more compelling.
Dilatush: I tend to look at the structured product market through a wider lens to include multiple wrappers or delivery vehicles and when doing so, holistically, there has been a considerable amount of growth.
In the annuity space, we have seen considerable growth in Fixed Indexed Annuities (FIAs) and Registered Indexed Linked Annuities (RILAs), as well as in the defined outcome ETF space. In the structured note market specifically, there has been increased advisor adoption in part due to technology enhancements to help with distribution and tracking of lifecycle events when holding individual structured notes in client portfolios.
A common misconception of structured products is that they are created in a black box and are loaded with fees. This is not the case. Advisors should be well educated on what they are buying and, if possible, establish direct connectivity with their preferred product manufacturers of these vehicles to ask questions.
Hortz: Why do you characterize structured investment strategies as solutions for “the next era of managing capital and risk”?
Sachs: Today’s structured products market versus 10-15 years ago is a lot more sophisticated with more players, variety, flexibility, and technology resources. The bespoke nature of creating structured products for portfolio construction and risk management needs is unparalleled.
As we look forward over the course of the next 20 years, we think that there are a lot of people out there seeking products with minimized risk that can still participate on the upside that will start using structured notes as they become more aware of them. Advisor adoption will continue as product development and technology continue to evolve to support structured investment strategies.
Hortz: Can you walk us through your selection and portfolio construction process in building concentrated structured note portfolios?
Dilatush: We utilize both a quantitative and qualitative approach for portfolio construction. We look at datapoints through the lens of the structured note payout to develop a times series for every suggested structured note to be considered for the portfolio. We can then run our correlations, volatility, and portfolio construction on those profiles.
Our quant team spent two years building the Selector, SCG's proprietary algorithm, to identify high-performing notes, mitigate market exposure, and mitigate correlation of individual positions. The results of the quantitative models are not only back-tested against historical returns, but also front-tested, out-of-sample, and out-of-time to enhance results against regime changes.
Once the Selector has suggested an optimized list of notes that complement the existing portfolio, our portfolio management team will then review the output and select a note to auction among a subset of our sixteen issuing partners based on portfolio credit exposure.
Sachs: The Selector has the capacity to model a portfolio of notes on a variety of underlying reference assets such as ETFs, single stock equities, or a wide range of indices across various payout profiles. We envision scaling the Selector’s capabilities to manage multiple bespoke portfolios subject to unique use cases and product delivery.
Hortz: How did you design the structured note portfolio for your mutual fund?
Sachs: Early on in our firm, we originally intentionally chose a higher volatility stock to be the single reference asset which allowed us to offer a higher coupon yield of say 25% that makes the note attractive. The problem that I had to solve for though was how do I get an attractive coupon without taking the idiosyncratic risk associated with one single stock that is embedded in the note?
We had to figure out how to create a product that generates a potentially high targeted annualized distribution rate while at the same time diversifying and minimizing risk. We did that by using sophisticated quantitative methods and our Selector algorithm to determine the best way to create an underlying structured note portfolio.
We chose a diversified pool of reference assets that do not necessarily trend with each other or the market. We chose that strategy for the Fund because the high weighted average coupon with the associated risk of the portfolio is very compelling from a risk/reward perspective. The way we combine the underlying individual reference assets is really what makes the Alternative Strategies Income Fund so compelling.
Hortz: Why did you decide to use a closed-end interval fund vehicle for your strategy? What do you see as the benefits of the interval fund structure?
Sachs: The interval fund structure is a great structure because it is widely accessible for everyone from institutions to retail investors. It fits the criteria for the mainstream investment community - it's a listed product, has daily NAV, allows for daily subscriptions with quarterly redemptions, and the quarterly redemptions are limited to 5% of the fund size, not 5% of any individual investor. The characteristics of an interval fund are very attractive for our strategy and it is also attractive for investors who would like the opportunity to invest in a much more sophisticated strategy than they can create themselves. It is really an ideal structure.
Dilatush: We also thought this out from the advisor’s perspective. Managing individual structured notes as an advisor can become burdensome very quickly. Each unique note held has its own lifecycle events to be mindful of - strike price and reference asset tracking, proximity to barriers or buffers, coupon payments, redemption or call events, corporate action events, issuer credit risk, daily market value of each holding, and the process to re-invest into a new structured note. Investors benefit from immediate access to a diversified portfolio across time, industry, and sector with low correlation to the broader markets. The interval fund structure also offers ease of purchase via a Nasdaq ticker as well as daily valuation.
Hortz: Any thoughts you can share with advisors on how to deploy your income-oriented structured note strategies for their client portfolios? What use cases do you see advisors employing?
Sachs: Our structured note strategies and interval Fund are perfect for an investor who is seeking higher income returns in our targeted 15% range and that has a well-diversified portfolio that mitigates risk and delivers what I would say is a very attractive risk/reward profile.
Dilatush: The Alternative Strategies Income Fund should be considered as an investment option when looking for income-generating products. We have seen advisors allocate to the fund as either a complement or alternative to individual income-generating structured note allocations.
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