At the time of writing in April 2020, we have witnessed one of the most volatile periods in the financial markets since the 2008 global financial crisis (GFC).
As the situation continues to unfold, it is clear that the crises of 2008 and 2020 are not the same. The GFC was a crisis derived from financial and credit concerns and was triggered by over-leveraged and under-capitalised banks. What we are facing now however is both social and economic in nature, changing the way we consume, commute and communicate. It has impacted different facets of life and is transforming the way we think and behave.
With the New York Stock Exchange triggering its circuit breaker three times in a span of two weeks in March 2020, the bullishness in the markets has dissipated. This is somewhat similar to what is still happening in major markets around the world whenever a new data set or measure is released. Fueled by uncertainty, investors make decisions contrary to fundamental trading and risk management principles. The mere thought of action on Covid-19 in itself can, unfortunately, give investors a sense of purpose and prompt them into action – often impulsively. The harder thing to do in such an environment is to actually deliberate, to consume the right data, to seek credible advice from experts and then finally make an informed decision.
A good understanding of human behaviour is vital in this time of crisis. I believe that how we think and behave as professionals in times like these - adopting a calm, measured and sensible approach to decision-making - will define us. In the future, wealth managers will look back and hopefully say: “These guys got it right on their watch.” And this is our watch.
A risk-first approach
Shifting our attention back to structured products, distributors in Singapore have worked with sell-side partners for a long time to prepare for a situation like this. The reason for doing so is due to the following considerations.
Distributors need to keep their clients at the centre of what they do to provide better wealth advice where clients understand the risk of an investment ahead of any potential reward. This prudent approach enables clients to build a firm foundation on which to grow their wealth. Maintaining a close engagement with clients is vital so that they are updated on the market outlook and movements and the resultant impact on their investments. In turn, distributors may make changes to investment solutions to safeguard their clients’ interests and to ensure the investments are the right fit in the current market situation.
For instance, during times when rates are low and volatility is high, we have started to see challenges for principal returned at maturity (PRAM) structures. There are, of course, alternatives such as opting for a credit-linked note which can help with the lower rate environment. Another approach is to use partial PRAM ie 90% instead of 100% at maturity to achieve participation if the investor is taking a longer-term view of three to five years.
We have also collaborated with our partners to provide a payoff which provides a combination of partial PRAM as well as an enhanced bonus coupon note. It capitalises on the high volatility environment to give clients a fixed coupon upon maturity as long as the worst performing share in the basket performs above strike ie 100% of initial level. Should the worst performing share trade above a pre-determined level – say, 110% of its initial price – the investor will get 1:1 upside participation. This type of payoff is suitable for investors who wish to take a view on a few shares and yet would like to limit or protect against downside participation.
Sound companies trading at discounts
Good value is now emerging, after the recent market swings. Now is the time to look at fundamentally strong companies which had been trading at historically high valuations and are now going at good discounts.
We always advise our clients who wish to increase their exposure to equities via structured products to take a view based on underlying value and be prepared to hold for the longer-term. After all, equity investment is about participating in the company’s performance and speculation should be left to the traders. Indeed, understanding the fundamentals of a company and performing due diligence on its management and corporate governance are what an investor should do.
For people who still wish to take the opportunity to buy some shares, another good payoff is the look back structure that enables the investor to capitalise on short-term volatility and set a lower entry point. Take step down auto-call structures as an example. They pay a coupon subject to knock out autocall events while providing downside protection up to a certain knock-in level. The look back feature enables the investor to use the lowest closing price for the next two to four weeks for each underlying share as the initial level.
For example, rather than using a strike and knock-out of $100 (100%), investors can choose a knock-in of $50 (50%), with a coupon of 10% per annum. The look back feature will observe the lowest closing price over the next two to four weeks and should the share record lower of $50, then the respective levels of strike and knock-out will be $50 with a knock-in at $25. If investors are keen to accumulate the shares, this structure allows a much lower potential entry point and uses volatility to its advantage.
Another solution is what we term a best of protection structure. It works rather like a step down autocall. By trading off the knock-in level, instead of a usual step down autocall, which will observe only the worst performing shares to determine whether the client will get back shares or the investment principal upon maturity, this best of protection feature will look at the best performer as well. If the best performer ended at or higher than a predetermined best of level of 105%, even if the knock-in level has been triggered and the worst performing share is trading below strike-at maturity (for example 100% of initial level), the client will receive the full principal at maturity. Such structures remove a key pain point in a traditional worse-off basket solutions and enable investors to benefit from the good selection of underlying shares by capitalising on the best performing share.
Finally, while structured products can help investors achieve their investment and financial objectives with innovative payoff, traditional investment and risk management practices such as dollar cost averaging, diversification, take profit and stop loss limits remain in the tool kit that one can deploy alongside structured products and other financial instruments.
If there is any lesson from the last financial crisis in 2008, it is that the acceptance of facts, adaptation to the new normal and a spirit of enterprise will help guide us out of challenging times. When guided by values such as prudence, discipline and responsibility, financial markets practitioners have the opportunity to show they are able to provide the right liquidity, credit, investment and hedging solutions to clients and build a legacy for future generations.