How active managers can extract value from the derivatives market
Structured products are investments designed to produce a tailored risk and return. They are generally constructed using a bond and an option, or other derivative, to create a single vehicle with a particular pay-off and a fixed term. It is easy to see why investors may be wary of such products, which can be complex and are often marketed aggressively as one-stop solutions.
So, are structured products too good to be true?
There are some interesting opportunities available in the structured products market. Products are priced using models which attach probabilities to certain scenarios, based purely on quantitative inputs. This gives rise to opportunities for active managers who use a range of inputs to form their market view, which may be more pragmatic than the results thrown out by the model. It is also possible for active managers to extract value from the derivatives market where they monitor secondary market valuations and trade tactically to take advantage of any anomalies. Structured products are useful for investors because their pay-off is determined at the outset. For example, an autocall may offer the opportunity to receive a 10% defined annual return if the FTSE is at, or above, its initial level on an anniversary date. If the index falls by 50% or more from its initial level, however, then capital will be reduced 1:1, in-line with the performance of the underlying index. If, at maturity, the index has fallen, but not as much as 50%, then they may receive back their initial capital but no capital appreciation*.
This allows the investor to know how their investment is likely to perform in certain scenarios. With reference to this example, the investor knows that they will underperform the index if it rises by more than 10% in one year as their return is capped. If the index has fallen by 50% or more at maturity, they are no worse off than investing directly in the index**; however, the structured product would outperform if the index is flat or has fallen less than 50%. Thus, structured products, when compared to actively managed strategies or passive investments, can offer a greater degree of precision and allow investors to skew the risks they are taking to better reflect their market views. It is far from prudent, however, for investors to simply look at structured products in isolation to the rest of their investment objectives – it is important to buy a product that fits within the context of the portfolio. When incorporated into a diversified portfolio, structured products can represent an efficient use of capital, enhance returns, reduce volatility, and eliminate undesired risks.
It is imperative that an investor understands the performance drivers for a product and how these might change over time. Economic cyclicality may affect participation rates over time. For example, fully capital-protected products showed very attractive participation rates in 2005 and 2006 when interest rates were higher, and low volatility meant that call options were cheap. We are now in a very different environment, with low interest rates and higher volatility, which means that products with a degree of capital at risk may be more optimal. Autocalls look attractive in this context.
Thorough due diligence is key, as is ongoing monitoring, when investing in structured products. Simply knowing your pay-off and counterparty risk is not enough, nor necessarily is holding the product until maturity. Investors should be wary of becoming ‘receivers’ of structured products, designed to look attractive, but not really meeting their specifi c goals. Quite simply, use structured products wisely and know your strategy before investing.
By Elizabeth Savage
*This payoff is delivered at maturity only, and the value of the investment may fluctuate intra-life, depending upon a number of factors including volatility, interest rates, and the issuer’s CDS spread, among other things. It is also subject to the solvency of the product issuer.
** Structured products provide a pay-off based on capital returns no total returns. A product may underperform a total return index in this scenario.
Structured products are based on the capital return of the index and not the total return. Investors forego dividends over the term of the product.