Investments in stocks and bonds are always exposed to the ebb and flow of the markets. When the market goes up you make money, and when the market goes down you lose money. Investors can dampen down the swings by holding a mixture of assets that tend to move in opposite directions. However this is tricky in times such as the present, when both equities and bonds are trading at expensive levels.
Risk can be controlled by keeping a portion of a portfolio in cash, but this means accepting somewhat lower returns. Alternative assets can be useful to diversify a portfolio, but there is still a risk that when the chips are down, such as during the 2008 crisis, investors become so spooked that all asset classes fall at the same time.
To ensure they can make money when markets rise, but also protect capital when they fall, an investor would need to look to the options market. Options are similar to insurance, but are often expensive and complicated, and can be difficult for individual investors to hold in their portfolios from an administrative perspective.
Rather than buying options directly, you can still benefit from them by having the bank package options together into a structured product. This is essentially a bond whose payoff is linked to the performance of an underlying asset. The product pays a return if the asset does well, but usually protects investors from all but the most extreme falls in the asset.
Structured products at work
With the level of volatility where it was in August 2015, at a time of global stock market turbulence due to fears around the Chinese economy, the Greek debt crisis and the prospect of an imminent US interest rate rise, we turned to a structured product with an attractive fixed return of 21 per cent per annum, while protecting against market falls of up to 30 per cent.
The product, linked to the FTSE 100 index, the US Russell 2000 index and the Euro Stoxx 50 index, would mature on the anniversary of its issuance if the worst performing of the three indices had gone up since August 2015. Investors would then receive their capital and a profit of 21 per cent for every year elapsed since the product’s launch. If after five years the worst performing index remained below its starting point then as long as it had fallen by less than 30 per cent investors would still get back 100 per cent of their initial investment. Only if the fall was more than 30 per cent would capital be lost.
The second anniversary has recently taken place, and with each index now above its starting point the product has matured, paying investors a 42 per cent profit.
As it has turned out, equity markets have been strong over the last two years and sterling has weakened considerably, so investors could have received a similar return by investing equal amounts in the three indices directly. This direct investment would not have had any protection if markets had been weaker however. In addition, the structured product would have paid the same 21 per cent return even if each underlying index had only risen by 1 per cent, making it a compelling investment.
How is this possible?
Why was the bank (in this case Société Générale) willing to issue a product that seemed to offer such attractive terms? The answer boils down to one of the fundamentals of investing: taking a long-term view.
When the bank evaluates pricing of a structured product it takes into account the current market conditions. Investors were nervous at the time, making the product returns high because the bank’s valuation models interpreted it as being high risk.
Long-term investors take a different view. A 30 per cent drop in markets, on top of the falls that had already taken place and no recovery within five years, seemed unlikely. The product certainly involved risk, but a potential 21 per cent annual return seemed adequate compensation for taking that risk. The value of the product may rise or fall during the term of the product, but it was unlikely to lose money over its full life.
The current situation is very different. The VIX, which measures expectations of future volatility, is close to historically low levels. A similar structured product bought today would pay in the region of 12 per cent per annum. Markets are also at much higher levels than they were in 2015, making larger falls at some point in the five year life of the product much more probable.
If we experience a period of elevated volatility in the future however, then investors may want to consider a similar product. It is always wise to remember the advice of veteran investor Warren Buffett to be greedy while others are fearful and fearful when others are greedy.
Matthew Hoggarth is head of research at Thesis Asset Management.
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