Bad Investments: Super Track Notes

Last Updated Jul 2, 2009 10:23 PM EDT

This post continues our look at structured note products. Today, we'll examine super track notes.

Like other structured note products, super track notes are debt linked to the performance of another security or index (such as commodities, interest rates or equities). The notes can also offer "enhanced" returns through the use of leverage.

Let's take a look at one particular offering from Barclays. This version was linked to the performance of the Energy Select Sector SPDR Fund with a leverage factor of two and a maximum return of 21 percent. If the fund returned 3 percent, the super track note would return 6 percent. However, if the fund returned 30 percent, the note would return 21 percent.

This note also had a buffer zone of 15 percent, meaning that if the fund returned between 0 and -15 percent, the note would pay off at par. This provides some measure of principal protection. However, if the fund declines by more than 15 percent, you lose 1 percent of the principal amount for every 1 percent the fund drops. Thus, the maximum loss is 85 percent of the initial investment.

It's important to remember that Barclays doesn't play Santa Claus. It wouldn't issue securities with higher costs than it would otherwise have to pay. In other words, if a security carries a high yield or has the potential to provide a high return, the security entails a high level of risk. Even if you can't identify the risk, you can be sure the risk exists. In the above example, the distribution of potential returns is highly unfavorable -- your maximum gain is 21 percent while your maximum loss is 85 percent.

You shouldn't make investments without fully investigating the risks. If you can't fully understand them, don't invest. Some investment products are so complex that it's very difficult (if not impossible) for you to fully understand the risks and the costs. Make no mistake about it: The complexity is intentional. If you understood the product, it's likely you wouldn't buy. That's why many such products are truly designed to be sold, never bought.

(Image of investment price going down by Mr. Thomas, CC 2.0)

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.