Risk/return analysis of structured products that helps select the best product for your clientsOctober 04, 2016 - 07:55
Every week we run our analysis on all of the structured products available to retail investors through IFA's. We aim to provide answers to three simple but important questions:
- What return might an investor receive?
- What risks do they face?
- What is the product worth?
Once registered, you can access this analysis through our website for a listing of all current products that you can filter and rank to identify the best product for your client. Alternatively, click here to download an XL sheet with all of the numbers.
RISK AND RETURN
This week we look at the relationship between risk and return. Our analysis allows us to show the wide range of products available and to demonstrate how risk and return are linked, but not always as you expect. We observe that some products are much riskier than others, but that this does not always feed through to the return that investors may receive.
CURRENT RETAIL PRODUCTS
VOLATILITY AND EXPOSURE
The chart shows clearly how volatility and exposure are closely correlated. The products with the highest volatility are also the ones where the day to day movement in the price of the product will be more sensitive to changes in the value of the underlying assets.
VOLATILITY AND RETURN
There is also some link between volatility and return. Both the Best Case Return and the Average Return tend to be higher as volatility increases. The chart shows how this relationship is quite weak, and that for many of the products with high levels of volatility there is no meaningful increase in the Best Case or the Average Return. So extra risk may not be rewarded by additional return.
VOLATITY AND XS RETURN
There is a strong, negative, relationship between volatility and XS return. As risk increases the XS return tends to decrease. The implication of this is that the more volatile products are riskier, but don't offer sufficiently more risk to compensate investors. The XS Return for many of the most risky products is negative.
- We see value for investors at the less risky end of the structured product spectrum.
- Riskier products offer the possibility of higher returns and more exposure to the performance of underlying markets, but XS returns can be negative.
Average Return: this is the probability weighted payoff discounted by the probability weighted term. We calculate the pay-off that an investor may receive from the product and when they may get this return. We use this data to calculate the average annual return.
Best Case Return: the 10th percentile return form our stress test. This is the dividing line between the top 10% of the results from the stress test and the rest of the results.
Exposure: the expected change in the value of the product today to a change in the value of the underlying indicies.
Volatility: we calculate the volatility of annualised returns using the Average Return and the average of the worst 10% of the returns from our stress test.
XS Return: the difference between the Average Return and the Benchmark Return. The Benchmark Return is the expected return from the mix of bonds and equity with the same volatility as the product. It is calculated as (5yr Gilt Return (0.2%) + Issuer CDS / 2 + (product Volatility / FTSE Total Return Volatility (18.5%)) x (Product Average Return - Gilt Return).
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.