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Gary’s view

Defensive Structures and when to employ them

19 January 2012

The Structured Investment industry is often hailed as one in which retail investors have a more alternative route to market in terms of underlying and the variety of pay-offs available. However comments such as "they're ideal when volatility is high", "when markets are low geared products have their place" or "kick-out plans are less attractive when markets are toppy" are consistently thrown around by many familiar with investment markets. But, in truth, the flexibility afforded by these gems of the investment world means that they literally can be structured to suit not only many different individual risk appetites but also many different investment market cycles.

Currently, one has to ask oneself is there really a good time for the retail investor to invest in the markets? To illustrate this point the table below highlights some interesting data on the FTSE 100 over the last 5 calendar years. The FTSE 100 is used here as it is widely recognised as the proxy benchmark for most asset managers and, with correlation figures where they are, broadly an indicative measure of most of the major world equity index movements.

There are 2 key themes that can be taken from this table. First, in each of the 5 years, the average volatility is higher than the long run average volatility in the FTSE 100 which is around 14 (based on average of rolling 30 day volatility). The second is, given that relative high volatility, returns were modest at best if not loss making with the exception of course being 2009. Interestingly, whilst 2009 did present some excellent buying opportunities, it was the 2nd most volatile year of the last 5 therefore I would add that hindsight is indeed a wonderful thing. Admittedly, the time period is not conclusive however many in the investment industry believe that the next 5 may indeed be similar to the last. In other words, markets are likely to remain volatile and move in a sideways fashion for some considerable time yet so where does today's investor find value with palatable risk? With regards to interest rates, the 5 year swap rate (a typical measure used by providers of Structured Investments but a good proxy for interest rates in general) has fallen from an average of 5.68% in 2007 to 2.27% in 2011, a drop in excess of 60% over that period with no immediate signs of improvement on the horizon; all in all a pretty gloomy picture for investors.

In terms of Structured Investments, we are starting to see real appetite for "defensive" type pay-offs where investors stand to profit where equity markets fall. Structured Investments with defensive pay-offs are not a new phenomenon but, in the current climate, are certainly proving popular with many different issues available from a variety of providers. Let me first say that a defensive pay-off does not necessarily imply a market fall. Structured Investments can work exceptionally well in sideways or to a point, falling markets which is a strategy rarely employed by traditional investments. For example, a product linked to the FTSE 100 offering a potential fixed return of 65% in a flat market over a 5 year period with full capital returned provided the FTSE 100 does not fall by more than half over the period does not seem particularly defensive but, in a sideways market is akin to a defensive strategy. There is of course counterparty risk to consider which can be also be collateralised potentially reducing an investor's exposure to any specific credit risk. Delivering a pre-defined return over say a 3-5 year period when allowing for a fall in equity markets is a valuable proposition that I suspect many investors would be interested in. It is also possible to build investments that offer "twin wins" delivering positive returns irrespective of market direction, Kick-out plans are offered where the kick-out feature is triggered where the underlying index (indices) on any observation point is below its starting level, typically at say 90%. There are also examples in some products where, on maturity, the index (indices) need only be greater than half of their start levels to generate competitive positive returns. Having said that, the pay-off profile is of course only one part of the "defensive" equation. Other variables such as term, optionality (American/European barriers), underlying asset exposure not to mention collateralised counterparty exposure can all be tailored to deliver defensive products that aim to mitigate and reduce a whole variety of different risks. Of course the more defensive the strategy, the more expensive the structure but finding the balance is definitely achievable so I would hope to see some real enhancements to our product suite over the coming months.

It would seem however prima facie counter intuitive to invest in a product that pays out when equity markets fall however many portfolios may in fact benefit from an element of "defence" when it comes to equity market exposure. Investors have a real fear of volatility however almost as equally worrying is the fear of "missing the market". Clients are also worried over market direction and why wouldn't they be? Short term market predictions have always been futile however even longer term, many experts are less certain on the course being set for equity markets. It is of course trite to state that to benefit from market upswings one must be invested in the market but, nonetheless it is true. Problematic of course with this particular strategy as already highlighted is the associated volatility.

Certainly in the short to medium term it would appear that equity market growth will be fractious, with market falls not uncommon therefore, whilst available, these "defensive" strategies should really be considered to let clients benefit from equity-like returns, without trying to second guess the market.