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Please read and agree to the following statements

Structured products are “complex instruments” this means that they will only be appropriate for you if you have sufficient knowledge and experience. In order to access the site you need to be able to agree to all of the following statements

  • I already hold other retail investments like funds, investment trusts or structured products
  • I consider myself to be a knowledgeable and informed investor
  • I understand the way that the investment return, the maturity value and any income are calculated by reference to the performance of underlying assets
  • I realize that I am not investing in the underlying assets but instead into a products whose performance is linked to these assets
  • I am prepared to invest into products where my capital is at risk
  • I have sufficient financial resources to be able to accept a loss on investments I make
  • I understand that the investment return and any coupon that I receive from structured products will depend on the performance of the underlying assets, and so I may not receive any investment return or income
  • The return of the capital may also be linked to the performance of the underlying assets.
  • I understand how this is calculated, and appreciate that the amount that you receive back when a product matures may be less than I paid for it
  • The defined value of each product will only be realised if the product is held to the maturity date. I understand that if I sell a product before the maturity date I will not get the defined value, and the amount that I receive may be less than the amount that I invested.
  • I understand that if the issuer is unable to meet their obligations to pay the amount due when the product matures, that I will not receive the defined value and will lose some or all of the money I have invested
  • I understand that there are charges built into structured products.
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Research & Analysis

Higher returns from new indicesDecember 08, 2016 - 15:10

Most structured products are linked to the performance of the main equity market indices. These offer liquidity and benefit from a high level of visibility, but there can be drawbacks as we describe below. Recently some index providers have developed new indices that can be used in structured products that mitigate some of problems with the main indices.

From our perspective, structured products linked to these new indices can have better terms than those linked to the conventional indices.  This note describes the problems with the main indices and the fix provided by these new indices and discusses the benefits and disadvantages of each. We can look at the effect on product pricing and conclude with our thoughts about the benefits and disadvantages of each.

THE PROBLEMS WITH THE MAIN INDICES

The main indices suffer from two main problems:

- Cheap implied dividends

- Large cap exposure

The low level of implied dividends is a technical issue that is largely a result of the large volume of structured products that have been offered that are linked to price return indices. Cheap dividends reduce the terms available on structured products. The large cap exposure is an investment problem that is a result of using indices where the weights are defined by market capitalisation. 

THE DIVIDEND PROBLEM: CHEAP DIVIDENDS

One of the common criticisms about structured products is that investors don’t benefit from dividends. This is patently untrue, but the way that this exposure comes through is perhaps not obvious. One fact that is true is that the level of dividends used to price products is lower than both the current level of dividends and the level of dividends that is forecast by analysts. This matters, because if implied dividends were in line with fundamental expectations the returns offered by Autocalls and other structured products would be higher. Investors are losing out because implied dividends are lower than bottom up estimates as we show in the charts below:

- Bottom Up dividends are the average dividend estimates from equity analysts and strategists

- Implied dividends are a value calculated based on the value of traded dividend contacts and the traded value of forward contracts for the underlying price return indices

 

As we can see from the charts above the level of implied dividends is lower than bottom up forecasts for both FTSE and Eurostoxx. The problem is particularly acute in the case of the Eurostoxx.

WHY THIS MATTERS

Structured products are priced using the forward price of the underlying index. This is not an estimate of where the index is expected to be, but a level that is enforced by simple arbitrage. At any point in the future the forward price is calculated as:  

Forward Level = Current Level x (1 + interest rates – implied dividend yield) ^ time  

So, if the implied dividend yield is lower, the Forward Level will be higher. A higher Forward Level will mean that investors receive less from assuming a risk to the final capital value, and must pay more to get exposure to an increase in the index. For structured products like Autocalls, a higher Forward Level means that if everything else is the same, the annual return will be lower.

LARGE CAP EXPOSURE

The issues with market capitalisation weighted indices have been debated extensively, and the growth of so called “Smart Beta” products is a result of the problems that have been identified. One of the main smart beta themes is a “size” effect. Smaller companies may offer better returns than large cap companies. A simple solution to this is to use an index where the weights to each constituent are the same. This reduces the weight of large cap equities and increases the weight of the equities with a smaller market capitalisation.

NEW INDICES

To mitigate the problem of cheap dividends and to take advantage of the size effect, index providers have created new indices that can be used in place of the conventional indices in structured products. These new indices are typically calculated using the total return from the underlying equities. The total return is then reduced by a fixed “synthetic dividend”. The fixed dividend is normally set to be close to the dividends that are forecast by analysts. Many of these new indices include some other features such as a broader range of companies. So the typical features of these new indices include:

-   Index value is equal to the total return less a fixed synthetic dividend

-   Equal weighting, so the exposure to each equity is the same. This means that these indices have a larger weight to mid-cap equities.

-   Wider equity base; the new indices tend to include a slightly larger number of shares than the core index. This reinforces the mid-cap weighting and reduces the exposure to the largest shares. 

The index providers argue that these features have been combined to help investment performance but it clearly also helps issuers of structured products to offer better terms, although it is less easy to make any direct comparison with the core index. They leverage the mid-cap outperformance effect that has been observed, so the performance of these indices looks good even with a synthetic dividend set at a level that is higher than the forecast dividends. 

Despite some reservations we think that for sophisticated investors these new indices are interesting underlying indices for Autocall, Reverse Convertibles and many other products.

THE NEW INDICES

PERFORMANCE COMPARISONS

The combination of the three main features of these indices to the core indices means that the past performance looks good versus the core indices. The charts below show the performance of two Natixis indices and compares these with the performance of the main equity indices.

FTSE 100 vs FTSE 150

The FTSE 150 has delivered a significantly better return than the FTSE 100 index despite the 5% synthetic dividend being set at a level that is higher than the actual dividend yield. 

EUROSTOXX 50 vs EUROSTOXX 70

The performance of the two European indices has been very similar despite the synthetic dividend being set at a level that is higher than the actual dividends that have been paid out. 

PRODUCT TERMS

To illustrate the effect of using these indices we have priced up two products with Natixis:

The product linked to the new indices offers an annual return that is over 2% higher than the conventional product. This is a significant uplift, and is largely attributable to the difference between the synthetic dividend and the level of implied dividends. 

POINTS FOR

- The maximum return from products that use these indices will be higher than the return from the same product that conventional indices because low implied dividends have been replaced with higher fixed synthetic dividends.

- The banks that issue products no longer have any exposure to actual dividends, and so can reduce the provisions for uncertainty that they include in their pricing

- Investors now have positive exposure to dividends. Investors will benefit if dividends turn out to be more than expected.

- The mid-cap effect has been reasonably stable, although investors should be comfortable with this risk

- The broader base and equal weighting across all constituents means that the new indices will tend to have more exposure to domestic rather than international companies.

- The broader base means that these indices have a more diverse asset base.  The effect on volatility is difficult to predict. Greater diversification would normally reduce volatility but the outcome depends on the realised volatility of mid cap versus large cap shares. 

POINTS AGAINST

-  Using a specialist index means that users are locked into the issuer. There is unlikely to be another bank that offers terms and so no one to check the product terms with

-  The bank may have reduced provisions for uncertainty, but they will almost certainly look to expand their gross margins (because they can)

-  The mid cap effect could go into reverse

-  If dividends turn out to be lower than expected, investors will suffer.

-  There is a material chance that the performance of the new index will be lower than the performance of the core index


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David Stuff
  • Author

    David Stuff

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.