Comparing Structured Products to a FTSE Tracker and cashApril 04, 2016 - 09:20
One of the problems that advisers can have when recommending a structured product is to demonstrate that the product is “better” than other alternatives. Our analysis offers a quantitative assessment of the returns that an investor may receive and the risks that they face. We can use this analysis to compare one product with another, and to compare one product with another investment like a FTSE 100 Index Tracker. This comparative analysis will illustrate when products offer a better combination of risk and return than other products, and against the benchmark investments. Our analysis shows that as at the 4th April 2016, there were twenty one structured retail products that are “above the line”.
We evaluate the risks that investors face and the returns that they may receive using a robust, reliable and transparant stress testing process. This process looks at the returns that an investor would have got using millions of hypothetical examples of how markets may perform in the future. None of us know what markets will do, but we can look back and see how markets have performed in the past. We use the patterns of daily returns to simulate how markets may perform in the future. This process means that we can test products many more times than a simple historic back test.
We use the same stress test process for structured products and for funds and other investments, so everything goes through the same process.
We run the stress test every week for every product. Once we have the results we can calculate the average return that investors would have received and the risks that they face.
- The average return calculation will include instances where the products have paid out the maximum return. It will also include instances where the product has not generated any return, and instances where the final value is less than 100%.
- The volatility we calculate is based on the average of the worst 10% of the results from the stress test. This means that it represents the risks that investors face. It also means that it is possible to compare the volatility of structured products against the volatility of funds and other investments.
The key to evaluating any investment is to gauge if the product offers more return with less risk than other investments. Our product analysis allows investors to do just that. We are able to calculate a “Benchmark return” for each product. The Benchmark Return is a combination of;
- The return that investors will get from a fixed rate bond from the same issuer with the same liquidity.
- For plans that buy securities we use the issuers Credit Default Swap (CDS) rate and the 5yr interest rate to estimate the return (this is 1.2% per annum at the moment.
- For plans that place money on deposit, we use the 5yr interest rate on its own.
- For plans that buy securities that have diversified credit exposure, we use the average CDS of the names credits.
- The average return that an investor may expected to get from a benchmark investment, and the volatility of this investment. We use a FTSE 100 Index Tracker as the benchmark. Our stress test suggests that the average return is 7.8% per annum, and that the volatility is 18.2%
- The volatility of the product.
The Benchmark Return is measure of the return that an investor would get from a combination of a fixed coupon bond and a note that offered the total return of the FTSE, where both of the benchmark products are from the same issuer and where the combination has the same level of volatility as the product.
Subtracting the Benchmark return from the average return we calculate for the product gives us the excess return for each product. If the excess return is positive the return from the product is higher than the benchmark return.
The chart above shows how the retail products available in early April 2016 compares with the average benchmark return.
- The average return of almost half of the products are above the benchmark return
- The highest excess returns are available from products with lower volatility.
- No product with volatility of more than 12% offers an excess return.
Comparing the return of each product against the benchmark return allows advisers to identify the products that offer the best risk/return profile. Additionally advisers are able to demonstrate that products offer a better risk return profile than cash and equities, expanding the efficient frontier. It is clear that the return from the higher risk products tend to fall below the benchmark return. These products typically have a high headline coupon. They may be suitable and appropriate for investors because an investor has a specific view about the level of markets in the future, but it is not easy to argue that these products offer a better mix of risk and return based on our analysis.
David has been involved in equity derivatives, equity structuring and the structured product market for over 25 years. Before setting up CUBE in 2013 David worked at J.P. Morgan, Barclays and RBS. David has worked with and for retail product providers, discretionary managers and institutional investors.