Building a robust investment portfolio: 3 ideas for how to diversify

As inflation decreases and the economy continues to grow, the market is proving more resilient than most forecasters had expected. Yet the picture is complicated. Consumer spending is softening, inflation is still above the Federal Reserve’s 2% target, and geopolitical risks are rising.

We expect corporate profit margins to continue to support stock values this year. But diversifying is still a prudent strategy. Now is the time to consider insulating your portfolio against future potential losses, or consider taking short-term tactical positions in specific asset classes as opportunities emerge.

Achieving these goals may be possible with certain financial tools. For example, by using structured notes, a pre-packaged investment vehicle that typically includes a combination of a traditional investment (such as a stock or bond) and one or more derivatives, you can improve the diversification of your portfolio, boost your investment’s risk-adjusted return potential and create strategies to guard against too steep a future market downturn.

Currently, some structured notes are more attractively priced than they have been in years. Why? Because higher-for-longer interest rates have significantly improved the pricing of these products, making them an interesting—and timely—choice for many investors.

To help keep your investment goals on track, consider how these financial instruments could help you enhance your portfolio. Here are the strategies worth considering now. 

1. Unlock potential opportunities to capture growth

Looking ahead, we expect economic growth to remain strong, even as interest rates remain higher for longer. In this environment, you can use structured notes to complement your core investment strategies, such as an equity allocation. These financial tools allow you to participate in leveraged upside returns of a particular stock or sector based on the strength of your conviction, or to position your portfolio to capture future returns without having to deploy more of your capital to buy more stock.

This can potentially enhance your portfolio.

For instance, if you have a specific market view, you can use structured notes to leverage your equity allocation. This is done by customizing your exposure using structured notes, such as a return-enhanced note (REN). This type of product aims to capture and amplify positive performance of a selected market sector or asset class, potentially up to a certain cap.

As long as the underlying asset does not close below its initial price at the REN’s maturity, the note will typically pay back the principal amount plus enhanced upside returns, since RENs include leverage. If the underlying asset closes below the initial price, some RENs offer full or partial principal protection, or some may result in a loss. The outcome can depend on the specific terms of the REN.

So, for example, if the market is up 10% and the structured note is customized to enhance returns 1.5 times, the position could be up 15%—and possibly outperform the market—depending on the note’s specific terms.

Any outsized returns generated by extended market rallies may be capped in some structures. But for sophisticated investors with a moderately positive outlook over a near-term investment horizon, RENs can offer a potentially attractive, time-limited payout profile.

Right now, with markets making all-time highs, it may be daunting to get invested, but structured notes that offer downside protection and compelling upside returns can be an appealing way to get invested and step out of cash.

However, as they are complex products, structured investments come with risks such as liquidity and counterparty risks, so ensure you fully understand the features, fees and associated costs, as they may not be suitable for all investors. For more details on the risks involved, please see the key risks section below at the end.

2. Reducing market downside risk while maintaining upside potential

Some structured notes can be tailored to reduce the impact of a market downturn on your portfolio while still allowing for potential gains.

These notes, known as market-protected notes (MPNs), can remove the full downside market risk of an underlying asset if the notes are designed to provide 100% market protection, while maintaining some upside exposure. They achieve potential upside through the purchase of an embedded long call option (with upside uncapped) or a call spread (with upside capped). Many investors find MPNs’ asymmetric risk-return profiles quite attractive right now—and preferable to the unhedged, long-only market exposure of ETFs.

Structured notes may also reduce the timing risk of stock market investing because the downside protection offered can help clients gain confidence to phase into equity markets. This approach can be particularly useful in avoiding common psychological traps identified by behavioral finance, such as hesitating too long to move out of a cash after a market dip.

MPNs, like other structured notes, carry inherent risks. A primary risk to consider is the potential for issuer default, which could result in the loss of your initial investment. It is important to thoroughly understand these risks before investing.

3. Gaining access to diversified income

If you want your portfolio to reflect your view on a certain asset—but you are equally interested in generating periodic coupon income—you can use a “phoenix note.” These structured notes, which are also known as periodic contingent coupon notes, are designed to provide potential coupon payments at regular intervals and reduce contingent downside risk until maturity.

Although they may seem complex at first glance, phoenix notes have some unique—and potentially beneficial—attributes. If the underlying asset’s price stays above a predefined barrier, these notes will make recurring coupon payments based on customizable review periods. They also have a “memory” function that accumulates unpaid coupons if certain market conditions are met. Although the notes won’t pay the coupon if the asset’s price falls below the barrier, previously unpaid coupons can carry over to the next review. At maturity, phoenix notes repay an investor’s principal in full if the asset is above the barrier; otherwise, the investor incurs a loss.

In short, a phoenix note may give you regular income and conditional protection against downside risk. If you’re seeking periodic potential returns and some degree of capital preservation, these structured notes could be very useful financial tools.

Conclusion: Preparing for any market eventuality

Stock market volatility is inevitable, but you can prepare for it. If you’re a suitable investor, by incorporating structured notes and derivatives into your portfolio strategy, you may be able to realize enhanced returns, protect your investments and access diversified sources of income. As geopolitical risks loom large this year, using structured notes could help you navigate a fragile world, take advantage of growth opportunities and, most importantly, stay invested.

We can help

If you’d like to explore how your J.P. Morgan team can assist you in tailoring strategies and payout profiles to help you meet your wealth goals, please reach out. We have deep knowledge and experience in designing customized strategies for our clients.