Over the past few years, the number of exchange-traded funds (ETFs) and mutual funds with a defined target outcome has increased rapidly. Nowadays, most US investors can find listed investment products with strategies such as protection, growth and protection, growth, income, and income and growth, as well as different payoff profiles as an alternative to long-only investments.
The increased speed at which information is shared and the impact of quantitative easing has made trading much faster than before, and this has translated into increasing short-term market volatility. As a result, ETF and mutual fund providers - while trying to find a solution to reduce risks and attract clients - have found the perfect solution: structured products.
With trade wars, central banks changing their interest rates policies and fears of a global economic slowdown, investors need to be much more tactical when it comes to allocating their capital. In order to offer this tactical exposure, ETF providers started to include derivatives and more specifically options in their tracking strategies. By combining index strategies together with options, investors are able to shape their potential return(s), as well as select the level of protection that they need or the participation and income, in the same way they would do with a traditional structured product.
Even if the US Securities and Exchange Commission (SEC) doesn’t regulate them in the same way, they are built putting together an investment vehicle with a derivative instrument, which makes them, with exception to their legal name, a structured product.
So, what is the difference between ETFs and structured products?
Structured notes and defined target outcome ETFs offer a similar risk-return profile to investors, but with one main difference: structured products are usually debt instruments issued by banks, which means the investor is exposed to the credit risk of the issuer. However, ETFs are a type of fund that owns underlying assets and divides ownership of those assets into shares, which means no credit risk.
Following the 2008 crisis, the perceived counterparty risk became an increasingly important factor for investors and their advisors, as well as for regulators. The credit rating is usually inversely correlated to the credit spread that issuers pay for cash. As such, the higher the credit spread of the issuer (ie the lower the rating), the higher the return offered by the products it issues.
As such, the main advantage of a target outcome investment compared with a structured product is the lack of credit risk exposure. Other benefits include being wrapped as listed equity products and potentially having a more active secondary market. Nevertheless, its main benefit is also downfall. When buying a structured note, the investor is compensated by the credit risk, with a higher coupon or a higher participation which they don’t otherwise get with an ETF.
Listed products are one solution to some of the biggest drawbacks of the structured product industry - credit risk and liquidity. Yet structured notes still attract investors as, put simply, investors chase yield and, and even in the context of a massive credit event affecting most banks, it’s very likely ETFs will suffer too. Spare a thought for those poor derivatives…
