Understanding Structured Products
Credit crisis in 2008 highlighted the risks associated with complex derivatives and securitization. However complex and exotic derivatives have also helped to diversify risks in the form of structured products which are an integral part of alternative investments in wealth management and sustainability. Structured products, as described by the Financial Industry Regulatory Authority (FINRA), are securities derived from or based on a single security, a basket of securities, an index, a commodity, a debt issuance and/or a foreign currency and swaps. Structured Products are an integral component of alternative investments as an asset class. Structured products can be a plain vanilla product (composed of zero-coupon bond and put/call options) or can have exotic options (digital options, look back or knock out structures) and can be principal and non-principal protected. Structured products could range from simple index-linked structures which are principal-protected to non-principal protected structures having credit default swaps as an underlying asset class. Globally, low-interest rates have driven investors in search of high yield products apart from traditional asset classes like equities, fixed income, and real estate.
# Rise of Structured Products as an Investment Class in Asia
Structured products are among the fastest-growing products in alternative investments, especially in Asia in private banking and wealth management for high net worth investors (HNI investors with an investable surplus of $1 million.) Structured products help investors diversify their risk and form an important asset class in Markowitz’s portfolio theory of efficient frontier. Structured products can also be tailor-made by asset managers for investors (HNI/UHNI) depending on their risk profile, investment horizon, and view of the underlying index. Moreover, structured products appeal to the growing investment savvy investors who are sophisticated enough to understand complex derivative structures and investment strategies. According to Credit Suisse, global wealth is $253 trillion, with Asia, especially China, as the most significant growth market and not surprisingly has the second-highest number of millionaires next to the United States. After credit crises, the appeal of complex structured products that are more common in the United States and Europe declines, with more straightforward vanilla structure products being favoured, especially in Asia. Strict rules and regulations against complex derivatives and non-existent CDS market except for a few blue-chip companies and non-convertibility of currency esp. in India limit the scope of complex structured products in emerging markets. In India, about 90 percent of the structure products are equity-linked to Nifty, while in China, trusts and vanilla structures are routinely sold in unregulated shadow banking. Going forward as capital markets, especially the derivative markets, develop and become more complicated in emerging markets like China and India. Investors need to become more investment savvy; structured products will play a pivotal role as a diversification option compared to traditional asset classes like equities and fixed income. Today, structuring is fast becoming a tool in sustainable finance. Structured products linked to sustainable investing strategies, primarily environmental, social and governance themes are becoming a vital part of the portfolio basket. The global size of Sustainable Finance/ ESG/ sustainable investing is about $31.1 trillion, and asset allocation through bespoke indexes linked to ESG themes is a significant portion comparatively over the previous decade. J P Morgan launch of ESG platform for investing across trackers, principal-protected products, equity, credit and fixed income turned to be a critical enabler.
# Enablers in the financial markets
JP Morgan’s collaborative role with leading multilateral development banks in partnering with the World Bank and S&P Dow Jones for churning out indices linked to sustainable themes including green, social, and sustainability bonds proved to be a boon for Sustainable industry. Promoting ESG related asset sales through planting trees based on a certain threshold of ESG related sales led BNP Baripas to grow millions of trees. Notwithstanding corporate social responsibility, such schemes enable customers to understand the importance of structured products in wealth management and sustainability, driving innovation through iterative demand. The burgeoning sale of structured products linked to ESG is not diminishing with the rise of activism for social and environmental issues. Hedging for currency and interest rates is rapidly rising. Cross hedging by the Italian energy giant Enel for its $1.5 billion sustainable bond sale fosters market-making for investors and asset managers globally. The recent pandemic due to COVID-19 will further fuel the importance of sustainable finance to raise capital for social and charitable issues. The African Development Bank (AfDB) current $3 billion social bonds to fight the risk of the pandemic in Africa is the largest such dollar bond issuance in international markets. As more leading asset managers and supranational follow suit, the role of structured products in sustainable finance will increase to enhance participation of high net worth individuals as various avenues increase for attracting capital. As we advance, more high net worth and retail individuals will increase allocation to ESG based strategies nudging more structured products linked to the sustainability sector.
According to Warren Buffett derivatives might be financial weapons of mass destruction but when used judiciously it helps to diversify risk and add liquidity to the system.
The richest 1 percent percent f the world’s population now owns 50 percent of its total wealth, according to Credit Suisse. Why?? Is this information not disturbing?
The report has been edited for spell checks, elaborated with recent information on ESG since its original publication.
The middle Road has a detailed publication on Inequalities with a focus on India. Download the publication here.
A Note on Exchange Traded Funds
Exchange Traded Funds are a key part of portfolio management in Wealth Management. A note about them is added here. ETF, Exchange Traded Funds are on a meteoric rise globally. According to a report by PWC, ETFs in the US will grow to $5.9T by 2021, a whopping 23 percent cumulative annual growth compared to $1.6 trillion in Europe and $560 billion in Asia. ETFs are passive investment products that track an index with no objective in beating their respective benchmark indices. Exchange-Traded Funds are linked to multiple asset classes like equities, fixed income, and alternative investments. The S&P 500 would be the most diversified example of an equity index in the US. An ETF linked to the S&P 500 would replicate this index to deliver similar returns. ETFs are passive funds and not intended to outperform the underlying index, i.e., they make an Alpha of zero.
Alpha means outperforming the underlying index. Mutual funds form a collective pool of underlying assets benchmarked to various indices; to deliver superior returns compared to the benchmark—for example, equity mutual funds in the US, benchmark indices like NASDAQ S&P 500. If S&P 500 provides a return of 10 percent a year, an open-ended actively managed mutual fund linked to the S&P 500 is expected to return a rate higher than 10 percent. Hypothetically if the fund returns a 15 percent return, the fund has an alpha of 5 percent, i.e., the excess return compared to the benchmark index. There are many ways to measure superior performance, usually known as a risk-adjusted return. Examples of Risk-Adjusted Returns are the Sharpe Ratio, Treynor Ratio, etc. Beta helps in understanding risk-adjusted returns better.
Beta is the covariance of a stock or fund with the benchmark index. Example, a fund with a beta 1, means that if the benchmark index returns 10 percent, the fund is expected to give a similar return. The beta of 1.2 means the fund will return 12 percent when the index returns 10 percent, i.e. 1.2 * 10 while a beta of 0.8 gives 8 percent return when the underlying index returns 10 percent. The higher the beta, the more aggressive the fund’s investment strategy. Funds with a beta higher than one are known as active funds since they work on the investment strategy to return higher returns. Funds with a beta of 1 or less are known as passive funds. ETFs will always have a beta of 1. To share a few examples, ETFs linked to equity indices like S&P 500, NASDAQ, and SENSEX, usually replicated the index in many ways. The simplest is to have the exact weighted average mix of stocks in the portfolio compared to that of the benchmark index. There are more advanced ways based on optimization techniques to replicate the index. However, these funds, including ETF do include tracking errors that must be monitored closely.
Above brief video from the Capital Asset Pricing Model educational video. The middle Road will have an in-depth module on this topic under Investment Analysis and Portfolio Management. Refer to the Online Courses here. The middle Road launched a comprehensive online course on Capital Asset Pricing Model. Its a stand alone course and it can be bought here.
Over the long term, few equity mutual funds have beaten the returns of the underlying equity indices. Peter Lynch is one of the few fund managers who consistently outperformed the markets and has written many books on his investment philosophy. Research has shown that very few mutual funds and hedge funds have regularly returned superior returns compared to the market. At the same time, actively managed funds expenses are much higher compared to passively managed funds. Hedge Funds usually take a fund management fee of 2 percent of the assets under management and a percentage of profits as a revenue-sharing model. Assume that a hedge fund has 1 billion under management. A 2 percent management fee would translate to expenses of 20 million per year on top of a revenue-sharing model on profits. On the other hand, mutual funds don’t have revenue sharing of profits built-in within their expense structure. Exchange-Traded Funds have a marginal management fee structure over the long term, i.e., more than three years can deliver better returns than the majority of actively managed equity funds. Other investment options like Angel Investing, Venture Capital, and Private Equity come under alternative investments. They usually invest in unlisted companies, are illiquid, and have a nonnormal return pattern compared to returns from listed securities. Due to their passive investment strategy, ETF has a low churn ratio compared to active funds, i.e., buy and sell stocks in the portfolio and, therefore, less administrative and other expenses. ETFs are cost-effective compared to actively managed funds and should be part of your diversified equity portfolio. The amount of ETFs within the portfolio would depend on the investor profile, the cash flow requirement, risk-adjusted profile, among other parameters. ETFs are an excellent pathway of taking exposure across multiple asset classes, including alternatives like Gold. Holding physical Gold is not easy since one has to maintain a standardized measure, especially in denominations of 1 Kg with 99.5 percent purity. Reselling is not easy in physical form and has a carrying cost, i.e. locker costs in banks etc. Exchange-Traded Funds provide a cost-effective way of investing in these asset classes, including providing liquidity through exchanges for not liquid assets. ESG which makes up the bulk of sustainable finance includes ETFs based on different styles of investment i.e. negative exclusion, best in class etc. As the market of ESG rises among the global investment community, ETFs remain one of the most popular investment options for taking exposure across asset classes.
The report has been edited for spell checks, elaborated with recent information on ESG since its original publication.