vestr’s Head of Business Development, Stefan Wagner speaks with founding partner and CEO of Fortem Capital, Edward Senior in an insightful interview about Structured Products.
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I will probably speak about the UK professional investor market, but this may cover the European market as well to some extent. I would say: European investors tend to be slightly ahead of where the UK investors are but its all a similar theme.
The trends we have seen over the past 18 months in structured products are links to indices. Especially defined return investments, known by different names – auto calls, digitals, reverse bonus certificates. In essence: derivative-based investments are ordinary linked to equity indices like the Footsie (FTSE 100), the DAX, the S&P and more and all single stock underlyings. In the UK, it is predominantly index-linked structures and more specifically auto calls.
It’s well known that March 2020 was when Covid really kicked in with regards to markets specifically. Equity markets, S&P, Footsie stocks were down in excess of 35%. With that we saw massive spikes with implied volatility. What that meant: dividends within the derivatives space got smashed considerably.
In terms of trends in both innovation and payoffs has been around banks mitigating some more of the risks associated with the products that they offer.
What is key for an organisation like Fortem, who provides structured products individually and funds to the market, is to effectively work with the banks. And harness some of those cost-mitigations or innovations, and pass those benefits onto the investor. For example, what we are trying to do is effectively harness the best of both worlds. Risks that the investors might be willing to take, and banks being able to provide better pricing as a result.
Maybe just breaking down between payoff and underlying, most of the innovation in the last 18 months has been regards to underlyings in terms of payoff. With regards to the structured products we consider the risks that they carry, what we call discontinuity risk. So, the discontinuity risk comes from the digital payoff that is inherent within the structured products correlation risk.
A lot of the structured products in terms of the payoff are linked to what we call the worst of performing underlying within that basket. What that typically means is if you have a basket of say 2 or 3 underlying indices or stocks, the payoff or maturity is observed on the worst performing underlying index or stock, over that period, rather than the basket or the best of, for example. What that effectively means is that the banks carry correlation from the books and the discontinuity risk with regards to the digital payoff from maturity like you said. So it is a payoff.
In structured products they have this sometimes referred to as soft capital protection or contingent capital protection maturity. What that means is that if you have a product in the UK market – with 4, 5, 6 years time horizon, – that is the level of capital preservation observed at maturity. These products can have quite a significant, payoff or swing. It may swing between a 150% of the initial investment and 50% of the initial investment, if the underlying or one of the underlyings is at or around a very sensitive barrier.
The bank needs to have that capital preservation observed during the life of the product. The underlying index or worst-performing underlying index is at or above a predefined barrier, that locks in a small amount of capital preservation. The performance is observed through the life of the product rather than only at maturity. Likewise for the capital preservation, because they are not observing at maturity only. And it works for the bank that mitigated some of this significant discontinuity risk at maturity.
And then in terms of the other types of innovations relating to the correlation risk. Effectively switching the payoff. Rather than being observed on the worst-performing underlying index or stock is observed on the basket and that relieves the bank of some of the correlation risk.
Both of those features means that the banks are required to take less hedging costs. Less hedging costs for the banks means that they can transfer some of those savings onto the end-investor, which means better terms for the client.
It’s with regards to dividends. Most of the banks and a lot of the index providers launch a fixed dividend index. Effectively that transfers that dividend risk that the banks carry to the investors.
With a normal index, you have effectively, on a total-return basis, the price appreciation of the underlying shares. Including the dividends that they have payed out.
With a fixed dividend index, there is a fixed amount of dividend deducted from that index on a long-run basis. As an example, the Euro stocks has historically had a dividend yield overrun about 3, 3.5%.
But when you buy a structured product linked to the Euro stocks and the bank issues a structured product linked to the Euro stocks that is however based upon the price return version of the US stocks. This means that you as an investor only receive all the performance for the investment that is linked to the price return of the underlying index. The bank therefore has to make some projections as to what the dividend yield on that index is.
Yes, a lot of uncertainty. Stock analysts tend to only provide forecasts and theres only a certain level of transparency on stock or company dividends. Probably 1 to 2 years. Therefore, beyond that period, banks start to make projection forecasts as to what the dividend or the implied dividend yield of that index is going to be. And again, backdrop being a lot of banks got burned in March 2020, making forecasts on what those implied dividends are.
Banks also have risks departments forcing additional, more conservative assumptions. The assumptions they make around the future implied yields for the US index for example are probably below 2, 2.5.
The terms that investors can get for structured products linked to the US stocks with a much lower implied dividend yield is relatively speaking, inferior to what they received in the past, all of the things being equal. What you can do instead of buying a product linked to US stocks conventional index, rather buy a structured product linked to the US stocks with a fixed dividend in there.
Most of the banks and the independent index providers are quite flexible now in terms of the different levels of fixed dividends you can choose to link your product to. So you look at historical US stocks dividend yield, which were usually at 3.5%. Therefore I am happy to have an index that takes out a fixed dividend at 3.5%. Some may consider this rather aggressive given the Covid crisis, and prefer a dividend that is going to be a bit lower. For example, at 3%.
The point of it is that you can effectively design your structured product and link it to an underlying index with a fixed dividend that is higher than what the banks are implying with regards to conventional indices.
We can take advantage of banks wanting to transfer some of their risks off their books unto the investor. It translates to better pricing from an investor point of view. As long as you set the dividend at a sensible level and build your barriers and the product sensibly as well, it can be a win-win situation.
In sum, when you are setting these barriers when designing these products, you are not looking for an underlying that shoots the stars. You are looking for something that performs relatively speaking to the barriers that you have set.
That was probably one of the other trends we have seen. Structured products have been linked to the underlying indices like the Footsie 100, the US stocks.
We have observed the trend towards equally-weighted indices so Footsie 100 obviously. Each stock becoming 2.5 % weighted. From a pricing point of view it works for the investor because having equally-weighted capital return tends to result in the underlying index being slightly more volatile than the conventional. And with a lot of these structured products the end-investor is effectively selling volatility.
Selling volatility at a slightly higher level for an equally-weighted relative to a capitally-weighted index translates into better pricing at a product level. Also from an investment asset allocation point of view, it also lies with the investor to diversify the factor away from relative value for example and vice versa.
You can design these structured products or these defined return investments to provide for levels of capital preservation over the mid or long term. And the potential to provide for positive returns even in negative markets over the mid to long term. The way we position our progressive growth fund is to provide for a defensive equity allocation. Or an absolute return over the medium to longer term. Often a particular target is 6 or 7% annualised return over the medium or longer term. So, you won’t get 6 or 7% every year.
Actually that is what people need to keep in mind; when you buy a structured product, you take the credit risk of the issuer. If you buy as a diversified portfolio in a fund, the credit risk is pretty much 99% government sovereign debt. Which is significantly better.
When we launched the fund, we decided that we are going to target a reasonably defensive return of 6 to 7%. Although arguably given where equities are right now I think it is quite an attractive level of return. If you can buy a firm that delivers on that over the medium to long term. In addition to capital preservation on the downside of up to 40%, that is an attractive proposition.
We also include to negate the credit risk ordinarily associated with these types of investments if you buy them individually. We effectively back the credit with investment sovereign so UK government, Singapore government, Japanese government, US government and credit exposure for example. That is the funding effect.
If there is a significant equity market sell off, then these products can capture a lot of that downdraft.
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