Many investment professionals are confused when they first encounter worst of (WO) structured product strategies.
Modern portfolio theory tells us we need to diversify, and not to risk everything on one endeavour. When we include several assets in a portfolio, the fluctuation of the total value of these assets, or volatility, will be lower than that of each asset. This should reduce risk.
It makes intuitive sense. If one asset has a bad time, the impact of its poor performance will likely be reduced, because of the better performance of other assets in the mix. The effectiveness of such risk reduction is determined by how divergent their likely performance will be. The divergence is measured by the correlation among the assets. If the assets have a low or even negative correlation with each other, the price performance is likely to be more diverged, and the risk reduction will be more effective.
But a WO strategy flips the correlation coin. It is a way to improve the headline rate of return in a structured product. The final yield does not rely on the aggregated performance of all the assets as a basket. Instead, the return depends on the performance of the worst performing asset. The poor performance of an asset will not be reduced by better performance of other assets, and only the worst performance of any one of the assets in the mix is used to determine the final return.
Here, a low correlation between assets works differently for investors. It increases the headline rate of a structured product, as there is a higher chance that the performance of an asset that very low or even negative return will be used to determine the final return. In other words, the risk of getting a poor or even zero (and in some strategies, negative) return increases, and investors should be compensated with the higher headline rate.
Unlike traditional portfolios, when an increasing number of assets will improve diversification and reduce risk, a WO strategy with a higher number of assets will increase the return risk of the structured product. The logic is quite simple: you have more assets in the group, so it is more likely that one of them may deliver a bad price performance which affects the final return of the structured product.
Advisers and investors looking at WO strategies
Despite the intricacies relating to WO strategies, they have been popular in the structured product market for more than a decade. They are often used with reverse convertibles, autocalls or conditional income with autocall features (also known as phoenix).
In the current low yield environment, WO strategies are one way to get an attractive headline rate for investors. SRP data showed that currently there is £1.4 billion (US$1.81 billion) outstanding in WO strategies in the UK market alone.
And just like any investment strategies, once the investor or an adviser understands how these strategies work, they prove they can deliver excellent results for investors. Therefore, WO strategies continue to be widely used around the world, including in products for retail clients and high-net-worth individuals.
For an investor or an adviser, there are two main areas that they should pay attention to in investing in a structured product with WO strategies. The first area occurs at the stage in making the investment decision. And the second is the impact of the inclusion of WO strategies from a portfolio management perspective.
Deciding and selecting structured products with WO strategies
The headline rate is an essential factor to consider when making the initial investment decision. However, of equal importance is the likely outcome in terms of possible returns.
Here, the key information document (Kid) that a retail investor will get in the UK and Europe helps a bit. The Kid includes a section on stress testing, where the product manufacturer needs to show the likely performance of the product on a forward-looking basis based on neutral, best-case and worst-case market scenarios. The parameters and models used in such analyses are prescriptive to ensure the output is as objective as possible.
One piece of feedback we have seen on the stress test model in the Kid is the use historical data are used to construct forward-looking performance of the underlying assets and hence the final return of the structured product. The limitations of this stress test model are widely covered in different publications by industry experts and academics, so we are not going to go through it here. Suffice to say, the model prescribed by the regulator is just another model. In does not entirely remove any bias that one can find in financial modelling.
Furthermore, another critical issue in interpreting the stress test is that while the probability of each scenario occurring is documented in the regulatory model, it does not mean that this will be the actual probability of occurrence. The regulatory model cannot account for, for example, the impact of Brexit, or of the US-China trade war, or investors behaviour for a prolonged period of low interest rates.
Therefore, I recommend investors and advisers complement the results from any quantitative analysis, whether it is from Kids or from other models, by asking three questions before making an investment decision:
- What do you think the likely future performance of all the underlying assets used in the WO strategy, over the product term will be? Remember, if one of them performs poorly, you may end up with a return that is lower than the stated headline rate.
- Are you happy with the number of underlying assets used in the WO strategy? Are you able to form a market view for each asset, especially if the number is high?
- Is there a good economic or investment reason to have all those assets put together in the mix? If different asset classes are used (eg mixing stocks with commodities), remember that their price behaviours and volatility can be highly divergent despite a highly reasonable economic link.
Answering these questions allows investors to have a better understanding of how the investment can perform, in addition to the quantitative statistical data that one can get. This ensures that we are not investing in a structured product that involves a WO strategy on an asset that we do not understand, that we do not have a market view (will it rise, will it fall, will it be trading around the current level), or that we cannot explain the investment rationale in plain English.
By applying some common sense checks on top of sophisticated data, investors will be making a better-informed decision on a structured product that is suitable for them, and avoid any unpleasant surprises in future.
Ongoing monitoring of WO strategies in a portfolio
Imagine that you are managing a portfolio of UK, US and European equities. To enhance income from the portfolio, you have also included a phoenix structured product with a WO strategy linked to both the FTSE 100 and the EuroSTOXX 50 indices. Both the income and capital (either on autocall or at maturity) depend on the worst performing index.
How will you treat the investment in this WO strategy from an asset allocation perspective?
A common approach is to treat this investment as a standalone alternative investment. The structured product is used to enhance overall income level from the portfolio, and is often invested on a buy-and-hold basis.
The advantage of this approach is simplicity. It recognises the purpose of including the structured products in the first place. However, it falls short when one considers portfolio risk management.
After the strike date, the value of the structured product will depend on the performance of both indices. If the performance of these two indices starts to diverge, the value of the structured product will be more sensitive to the performance of the worst performing index since the strike date. If the worst performing index starts to fall, the value of the structured product could begin to fall, even though if the other index is rising.
While this drop in the value may not be a reason for concern as a buy-and-hold investment, there are two risk management consequences to consider:
- The worst performing index is affecting the likelihood of getting an income and getting an autocall. If the worst performing index continues to fall further, the original investment objective of getting enhanced income is at risk of not being met.
- As the two indices are in the same market as the rest of the equity portfolio, the WO strategy increases the exposure to the worst-performing market in the entire portfolio.
Monitoring the likely negative impact on product performance
Tackling the first problem is relatively straightforward. In this example, one should track the level of both indices since the strike date, and set review limits to look at whether the worst performing index will continue to fall, resulting in loss of future income, delaying autocall or even breaching any capital protection barrier. The review limits can be set at a fixed percentage above the income trigger level, the autocall trigger level, and the protection barrier level (eg 10%). The review limits can also be set based on the volatility of each index, such that the review for a more volatile index will happen at a level that is relatively higher than the one for a less volatile index.
The review is to consider whether the market conditions have changed such that the required performance for the product to deliver the expected outcome is no longer valid and whether an investor should exit the investment early rather than continuing with the buy-and-hold strategy. In the UK and Europe, such a review is part of the product governance that an adviser needs to do under Mifid II rules.
For more sophisticated investors and discretionary portfolio managers, the second problem will be relevant from an asset allocation perspective. Using the above product example, if the FTSE 100 keeps falling, the risk exposure to UK equities will increase as the structured product becomes more sensitive to the performance of the FTSE 100 index. If the manager decides to keep the allocation to UK low, they need to consider the effect of this indirect exposure to the UK, especially if the performance to UK equities continues to be weak.
In the case of the product example above, the perfect method uses the sensitivity of the structured product to movement in both indices, otherwise known as deltas for option experts. Using the deltas, the manager can look at actual exposure to both markets through the structured product, and can include those exposures to the allocation to the UK and European equities. Including these indirect exposures will help the manager to be more effective in managing the asset allocation.
The difficulty is that unless the manager can get the actual deltas regularly from the issuer of the structured product, or has internal models to estimate the deltas, the information is not readily available.
One alternative in determining the indirect exposure is to split it equally split between the assets. So, in the above example, a £10 million investment in the product results in a £5 million exposure to UK and European equities, respectively. However, this assumes that the underlying assets will behave like a traditional asset basket, rather than a WO strategy. As we discussed at the start, we know the structured product does not introduce diversification in these two markets. This method will, therefore, underestimate portfolio volatility and mislead the manager when they look at the overall asset allocation.
In the example above, one fix, which is more of an estimation than a precise measure, is to consider the market exposure via the structured product to be the worst performing index so far since the strike date. This method will likely over-estimate the actual delta of that index. But we know that if this worst performing index continues to perform poorly, the future behaviour of the structured product and its impact on the overall portfolio will be driven more by that index.
Using the above product example, if the FTSE 100 has been the worst performing index since the strike date, the approximation method above will increase the allocation to UK equities in the portfolio by the notional amount invested in the structured product. So, if 10% of the portfolio is allocated to the structured product, and the allocation to UK equities is 30%, the effective exposure to UK equities is now 40% of the portfolio. The manager can then assess whether this allocation is appropriate if their outlook on UK equities has turned negative, and takes action to adjust either the allocation to UK equities or the structured product. The manager may choose to reduce the structured product allocation if, at the same time, the product monitoring process reveals an increased likelihood of the structured product not delivering the expected outcome.
Importance of lifecycle monitoring and management
The above discussions show the importance of a proper lifecycle monitoring and management system to help advisers, managers and investors manage structured products with WO strategies more effectively in portfolios. The system should allow users to set review limits based on the key trigger and barrier levels. Ideally, the system should also connect to the structured product issuer, such that information like deltas can be fed and integrate with other asset allocation systems or spreadsheets.
With the structured product market embracing technology more than before, such tools are immensely useful for structured products end-users. They can then put some of the suggestions in this article into actual practice more efficiently. Better monitoring means more investors and advisers will feel more confident in using structured products in their portfolios, ultimately helping structured products to be seen as an indispensable component for different types of portfolios.
By James Chu, founder and director of Alphamax Capital