In recent weeks nearly every asset class has seen remarkable and unexpected price movements. Structured products are often used in modern investment portfolios to reduce risk and or diversify returns, but prices have been as volatile and disconcerting as many other assets. In this article we answer five questions to explain how products are formed, why these are used and the factors that determine pricing.
What is a Structured Product?
Structured products are issued by large, global banks and offer investors exposure to the global equity derivatives market, which is both large and liquid. There are two types of product that we invest in:
- Defined return structures – These products offer a ‘known’ annual return, provided a stock market does not fall by a specified amount during the product’s life. The most common type is an Autocall, which can redeem on any ‘anniversary’ date before it matures.
- Participation structures – These products offer a ‘geared’ return on the underlying stock market and therefore tend to be used to express a positive view on a stock market index.
Any structured product we invest in has two components. The first is a zero-coupon bond issued by a bank. The second is the derivatives that provide returns linked to the chosen stock market.
What are the ‘derivatives’ used in these products?
- Call options - These options give the option holder the right to buy an asset at an agreed price, during a fixed time period. These are bought if an investor expects the value of the asset to rise. For example, one might buy a FTSE 100 call option if they believe the UK stock market is going to appreciate.
- Put options - These options give the option holder the right to sell an asset at an agreed price, during a fixed time period. These are bought if an investor expects the value of the asset to fall.
What factors affect the value of a structured product?
The most important determinants of a product’s price include:
- Stock market performance – We invest in products with returns that are derived from highly liquid markets, including the FTSE 100, S&P 500 and EuroStoxx 50. The performance of the underlying index is the most important factor driving these products.
- Volatility – When volatility rises, the value of the call and put options increases. This is because the possible returns on the upside or the downside are heightened in more volatile conditions. Higher volatility has been a key feature of the market weakness we have seen during March.
- Credit risk of the issuing bank – If there are concerns over pressures on the issuing bank, or the broader financial system - such as those experienced during the Global Financial Crisis in 2008 - investors will also attach a premium to owning the bank’s debt and therefore the value of the product will decrease. Unlike the Global Financial Crisis in 2008, the Coronavirus crisis has not been caused by vulnerabilities in the banking sector. We have strict governance rules in place to ensure that we only invest in structured products issued by high quality, creditworthy banks.
- Dividends – One of the key features of most structured products that we invest in is that the investor foregoes the dividend payments of the underlying stock market. It is widely expected that dividend cuts during this crisis will exceed those seen during the 2008 crisis. Structured products tend to offer more attractive returns on higher yielding stock markets, which have traditionally included the UK and Europe and as these dividends have been cut, the prospective returns on structured products have fallen.
- Interest rates – In this very low interest rate environment, the value of put options is high because investors would rather own the ‘risk’ asset alongside a put option as insurance, instead of keeping the cash in the bank earning no interest. Conversely, call options are in low demand because investors generally own the ‘risk’ asset, as opposed to keeping cash (earning no interest) and buying options to participate in the upside.
- The time until the product matures – We tend to observe that pricing is most sensitive near a product’s anniversary or maturity dates, when it is unclear whether a product will mature.
How do these products behave in volatile market conditions?
We have seen some of the most severe market conditions ever experienced and the volatility in structured product pricing has been pronounced during the past month. Although investors will have seen the value of structured products fall during this time, the products tend to have defensive ‘capital protection’ barriers. Most of our products allow the underlying stock market index to fall by 30-40% during the product’s life before the investor’s initial invested capital is at risk.
How can structured products add value to a client’s portfolio over the long term?
- The products can be designed in a bespoke fashion to reflect the investment manager’s view on a particular stock market.
- The products allow investors to benefit from the ‘quirks’ of the derivatives market – for example, the downside protection that we often sell when constructing a product (the put options) is in high demand as a result of institutional investors, such as pension funds, requiring insurance for their equities. The end investor is therefore paid handsomely to take on some of this risk.
- Based on historical returns, the probability of any stock market falling sharply and not recovering during the average life of a structured product (between 5 and 7 years) is very low.
The short-term sensitivity in structured product pricing is much higher when we see a sudden decline in the underlying equity markets, such as that which we have seen during the past month. Indeed, it has been the fastest ‘bear market’ – defined as a 20% fall from the recent peak – in history. This pricing volatility does work both ways and if fears over the long-term economic impact of Coronavirus subside during the coming months, we would expect a significant recovery in the value of these products.
Please remember investment involves risk. The value of investments and the income from them can fall as well as rise and investors may not receive back the original amount invested. Past performance is not a guide to future performance.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of publication.
Smith & Williamson Investment Management LLP is part of the Smith & Williamson group.
Smith & Williamson Investment Management LLP is authorised and regulated by the Financial Conduct Authority.