Three reasons you should be looking at structured products nowMay 04, 2016 - 09:15
Investors that have
used structured products linked to the main equity market indices have every
right to feel pretty happy with themselves. Their structured product investments
will probably have delivered a higher return than equities or bonds with less
volatility (see the table below). This performance is not just a flash in the
pan but instead exactly what was expected. Our analysis suggests structured
products will continue to deliver good returns with low volatility. We propose
that investors should increase their exposure to structured products and
decrease their exposure to equities and bonds. A diversified portfolio of
structured products like the new Managed Portfolios we have developed with
James Brearley offers an
easy and efficient way to benefit from the superior risk / return that these
have always had a “does-what-it says-on-the-tin” appeal and this is an important
part of why investors use them. However, in the current market investors want more than an accurate description of how the product works. Investors
need to know if products are suitable and appropriate. They want to know about
what return they can expect to receive and the risks that they face. They want
to know how the risk and return compares with other investments. We have been
analysing structured products for more than four years. The techniques that we
have developed are very similar to the new regulatory standard published by the European Union. The good news here is that our
analysis shows that good returns with low volatility that these products have
delivered is entirely consistent with the risk and returns that these products are
expected to generate in the future using our stress test.
We see three strong
reasons why investors should be considering structured products now:
past performance demonstrates that these products have delivered good returns
in testing market conditions.
products can be designed to offer good returns when markets track sideways.
analysis shows that these products can be expected to offer a better
risk/return than conventional portfolios.
Our first reason is to
look at structured products is that they have delivered a great return. We all
know that past performance is no guide to the future, but equally it is always
comforting to see how a product has performed in the past.
The good past
performance of structured products is irrefutable. This must be a bit galling
for those investors that have not used these products in the past. We calculate
an index of FTSE Kick-Out product performance. The index is simple, each day
the change in the index is equal to the average change in the value of each
product in the index. There are 78 products in the index at the moment. We
include every FTSE linked Autocall that we can find where the price is
published every day. The table below shows how the performance of the index compares
with the returns from the FTSE iShare.
DESIGNED TO OFFER POSITIVE CARRY IN A
It’s hard to see what
assets are going to offer an attractive return in the future. With rates at
current levels the return from equities and bonds many analysists and investors
are revising down their expectations of future returns. Asset managers will not
be able to rely on the tide of rising process to to generate returns.
Our second reason to
invest in structured products now is that structured products are one of the
assets that offer the prospects of good returns if markets drift sideways. For
many products all that is required for a positive return is that the index
level remains unchanged. For some defensive products the maximum return will be
offered even if markets fall over time. Structured products are designed to
generate positive returns in sideways trending markets.
There is an
opportunity cost of investing in structured products; the return is generally
capped. If we assume that reasonably conservative portfolio of structured
products offer a headline return of about 8% per annum, how significant is the
opportunity cost? For equities to offer 8% per annum over the next 6 years (this
is about a 60% return over the period) the level of the FTSE would have to
increase by about 30% with the remainder coming from dividends. So with the
FTSE at about 6,200 now this would mean that structured products may
underperform if the index level increased to more than 8000 by 2022. This is
not impossible, but it seems to be a stretch.
On the downside the
maturity value of most products striking now will only be less than 100% if the
level of the FTSE is below 3700 or thereabouts when the product matures
(assuming that it has not kicked out before then). While this is not
improbable, if investors think that a 40% decline in the level of the main
equity markets over the next few years is a significant risk, then they should
be very wary about any equity based investment.
IMPROVED RISK / RETURN
The FCA has for a long
time required structured product manufacturers to stress test products. The
European Union has gone a step further and prescribed a way that this should be
done. They require promoters to calculate the returns that investors may get,
and the risks that they face.
Our third reason to
buy structured products now is that the stress testing process mandated by the
regulator show that many structured products offers a better risk/return than
portfolios of conventional assets.
This stress test means
that we can compare structured products with each other. We can also compare
structured products with other investments. The chart below shows the risk and
return of over 200 products trading in the secondary market.
Each product is
represented by two markers:
- The blue
marker is the risk and return of that product from the stress test
- The orange
marker is the mix of 5-Year Gilts and FTSE tracker that has the same
volatility. The orange marker includes an adjustment for the issuer risk.
The orange markers act
as a benchmark return. For products where the blue marker is above the orange
marker the product offers a better return for the same risk as a combination of
FTSE and Gilts.
It is clear from this
chart that many (but not) products offer a mix of risk and return that is very
attractive. One particularly striking feature of this analysis tis that
Structured products offer balanced investors (less than 15% volatility) and
cautious investors (less than 10% volatility) the prospects of much better
returns than equities and gilts.
The investment case
for structured products is very sound.
- Our index
of product performance shows that they have offered good returns in the past.
- Our stress
test shows that they can offer attractive returns in the future.
structured products are designed to offer the prospect of good returns even if
markets drift sideways.
Our conclusion is that
structured products should be a part of every investors portfolio. They are
particularly attractive for investors who think that returns from conventional
portfolios will be low over the medium term. We would advocate using structured
products to replace equity assets. This switch reduces risk, maintains the
potential for return, and increases the chance of receiving the return.
As with all investments there are some simple rules for success:
is vital, investors need a spread of issuers, underlying assets and strike
- It is
important to understand the risk and return of each product.
We also know that
unless a product is easy to use, it will be ignored. Individual structured
products can be labour intensive for investors and advisers. The Managed
Portfolios that we have developed with James Brearley offer investors an easy,
efficient and attractive ay to get exposure to an expertly managed portfolio of
structured products. Click here for
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.