Higher returns from new indicesDecember 08, 2016 - 15:10
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.
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
THE PROBLEMS WITH THE MAIN INDICES
indices suffer from two main problems:
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:
Up dividends are the average dividend estimates from equity analysts and
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
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
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:
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
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:
value is equal to the total return less a fixed synthetic dividend
weighting, so the exposure to each equity is the same. This means that these
indices have a larger weight to mid-cap equities.
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
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
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
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
EUROSTOXX 50 vs EUROSTOXX 70
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.
the effect of using these indices we have priced up two products with Natixis:
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
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.
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
now have positive exposure to dividends. Investors will benefit if dividends
turn out to be more than expected.
mid-cap effect has been reasonably stable, although investors should be comfortable
with this risk
broader base and equal weighting across all constituents means that the new
indices will tend to have more exposure to domestic rather than international
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.
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
bank may have reduced provisions for uncertainty, but they will almost
certainly look to expand their gross margins (because they can)
mid cap effect could go into reverse
dividends turn out to be lower than expected, investors will suffer.
is a material chance that the performance of the new index will be lower than
the performance of the core index
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.