It may come as no big surprise that you wouldn’t have much luck trying to purchase flood insurance for your home on a barrier island in the middle of a catastrophic hurricane. However, let’s say that by “lottery luck” you were somehow successful in your endeavor to purchase an insurance policy the price would no doubt be at quite the premium. By comparison, investors have the luxury of liquid and accessible markets daily regardless of what volatility is occurring in the world. As a result, the ability to purchase protection on the market through a put contract is simply a click away!
That said, investors can still expect to pay a premium for insurance when market conditions are frothy in fear just like a homeowner trying to purchase a flood insurance contract would garner as a hurricane is rolling in. To get an idea of what that massive premium may be, an investor can gauge the CBOE Volatility Index (VIX), which measures the level of implied volatility currently priced in the S&P 500 options market. A VIX index in the 20’s is rather frothy, while levels closer to 10 is straight up cheap.
Unlike in the traditional insurance world, where the client is the home owner and the provider is the large insurance company, investors can take part in either side of the market transaction. That means an investor can decide that the premium is indeed very frothy and go ahead and sell insurance to another investor who may be more concerned and is looking to protect further downside.
Insurance is purchased for almost every aspect of our lives from health and disability to our homes and cars in order to protect us from a liability or bad event that could be financially inconvenient or even worse. The money that we pay for such insurance—the premium—is usually an obscure amount which only an actuary could understand how the bill is calculated. Yet the insurance bill always seems way too expensive until an unfortunate event occurs in which case it is no longer perceived as a necessary evil that costs us a fortune.
If you think that insurance costs are a little on the high side, think again! In fact, one of the most important and complex life costs that we will ever face is retirement. This is especially true since life expectancies are growing from years past whereby retirement costs were mostly assisted by pension plans that guaranteed fixed payments retirees for life. However, defined benefit plans (pensions) are essentially becoming extinct with only 4% of private sector workers solely relying on one; down from 60% in the early 1980s. As life expectancy continues to increase, it is putting pressure on what has become almost a herculean task for us to save up enough during our working years to cover retirement expenses.
In early September I wrote about the effects of uncertainty on financial markets and investing. There is a high level of correlation between fear and ambiguity, which the recent market downturn snapped into focus. When all is going well, whether in the markets or generally in life, people feel rather good and tend to focus less about what may go wrong in the future.
But when things aren’t going well or as planned, our minds seem to launch a critical review process, whereby we create a narrative and attempt to use that in guiding us to a solution. The worst is not knowing the root of the cause or the solution, or whether it will all get better or worse.
October Swoon Aside, What’s Next for Financial Markets?
October marked the worst month for U.S. markets since the 2008-2009 Great Recession. Toward the end of October, after the Nasdaq led the markets down roughly 9%, a colleague sent me a message from a pundit on one major news channel stating that the stock markets will collapse. My colleague also noted that a few clients had nervously sent it to him asking for advice. In turn, I did a Google search on a market rally and sent him the first article that popped up stating another pundit who believes we will rally into the end of the year. We can all prognosticate but the reality is that the market is so dynamic with many inputs and information. Still, it is simply impossible to know what the future holds for the market.
On a recent trip to the Baltimore/Washington D.C. region, I had the opportunity to meet with several financial advisors over lunch to discuss their methods of mitigating risk within their credit portfolios. We discussed the viability of using a conservative defined outcome strategy that is designed to provide a tail-risk hedge to the equity market, while also serving as a good replacement vehicle for a portion of their fixed income portfolio.
During our discussion, several key themes emerged:
- First, how should advisors and investors position their fixed income portfolios?
- Second, with yields still at historic lows, there is uncertainty regarding how bonds may perform going forward and whether a decline in fixed income markets would trigger an overall market downturn.
- Third, is there an upside to blending a portion of defined outcome strategies with ones fixed income portfolio?
John walks into a deli and asks what sandwiches are available. The counter guy responds that there are two choices: A turkey hoagie or pastrami on rye. John replies that he will have the turkey sandwich. A minute later the counter guy says “oh yeah, we also have a chicken salad sandwich to which John replies, you know what, I will have the pastrami on rye. This seems very illogical. John was presented a choice between item A (turkey) or B (pastrami) and chose item A. Conceptually, he was then provided a choice between A and C (chicken) – yet decided to choose B!
Uncertainty, also known as ambiguity, has a crippling effect on us humans generally. It keeps people from making the right choice from a probability standpoint in all aspects of life – switching a job, dating, which supermarket to go to and where to live are just some examples. As a group we would like to believe that we are hyper logical despite overwhelming evidence to the contrary (e.g., Illusory Superiority, Anchoring, Herd Behavior). The subject has been on my mind given the dramatic effect it has on both the way people think about and invest in the financial markets and the fact that most investment strategies, especially hedging strategies, tend to heighten uncertainty of returns rather than mitigate them. It is worthwhile examining the cost to this uncertainty, a cost that has still not been well defined in the financial markets. The best duo to begin this examination is with Daniel Kahneman and Amos Tversky, pioneers of Behavioral finance.
Barron’s wrote a cover article, “The Annual 50 Best Annuities Review”, in their July 22, 2018 edition with a section that highlighted the growing success of Structured Annuities. The article helped answer a question that has been weighing on me as of late, the question being: why are buffered products so much more popular than floor (aka Shield) products? My firm had done both qualitative and quantitative research on market preferences in regards to market exposure and found that a buffer product and a floor product had similar demand. However, when looking at issuance of Structured Annuities, the vast majority are of the buffer product variety. The answer came in an added comment at the end of an expressed view: “Generally, the upside caps on the floor products are a little lower”, she adds. (Thanks Jessica!)
To review, a buffer product provides initial protection to the downside while a floor product provides tail-risk, or second level protection to the downside – a “floor” (or shield) to your risk rather than a “buffer” of risk. For example, a 10% buffer on the S&P 500 is designed to protect on the first 10% decline but provide no protection thereafter. So a 10% decline in the S&P 500 should result in the investor recouping their capital while a 30% decline in the S&P 500 should result in a 20% loss for the investor. A 10% floor (or shield) product should protect declines that surpass the floor level. So a 10% decline in the S&P 500 should result in a 10% loss for the investor while a 30% decline in the S&P 500 should also result in only a 10% loss for the investor.
What is interesting is that the longer the duration of the buffer the more the investor has to spend on upside participation as compared to a floor. Most of the structured annuity issuers provide one year, three year and either five or six year maturities. The recent low volatility and low yield environment has resulted in better seeming characteristics in longer termed maturities. As can be seen from the graph below, the buffered note provides materially more to spend as duration increases.
One of the ultimate strategies for a concentrated position is the zero-cost collar. The scenario presents itself when an investor has a large position, typically due to a job at a publicly traded company that pays a portion of compensation in stock. Over time, the stock becomes a significant component of net worth that may be difficult to exit due to significant tax consequences among other potential issues. The real problem lies in the risk to the downside of this single position. A negative event can result in a spiral down for both the stock and the investor’s net worth, unraveling years of hard work.
While there are a number of approaches to diversify around the position and look to mitigate the effect of a concentrated position, one of the best tools is the costless collar, also known as a zero-cost collar. A costless collar is an options strategy that “collars” the stock through the purchase of a Put below the current market value of the stock while selling a Call above the current market value. The Put serves as tail-risk insurance for the underlying security as it provides the right to the owner to sell the security at the agreed upon “strike” price of the contract. The investor is protected from a major negative scenario where the stock takes a material hit in value due to this Put. Like all insurance, a premium must be paid and a Put is no different. That is where the Call comes in. The investor can collect the premium necessary for the Put by selling the Call. While the Call allows the Collar to be “costless” the Call itself comes at the cost of the stock getting “called” away given a decent move to the upside. The risk of losing the premium on the Put is traded for the risk of capping upside returns.
“Buffer annuities will continue to grow in popularity: Blackrock research finds that 39 percent of retirement savers would move further away from their cash holdings if their capital was protected. As cash continues to be a non-performing asset, interest in products that offer upside potential and downside protection will increase” – Point #1 in “Critical Trends in 2018” from the Insured Retirement Institute (IRI) State of the Insured Retirement Industry 2017 Review & 2018 Outlook
The top trend according to the State of the Insured Retirement Industry is for the buffered annuity and like products to continue to grow in popularity. That is quite the statement given what the category has done from its creation in 2010 by AXA, a mere eight years ago. According to LIMRA, there were $9 billion in buffered annuity sales in 2017, a 250% growth spike in a three year period. Now they are on the verge of breaking out as a category killer.
February was a good test run for the inevitable market downturn. After being on cruise control for approximately two years the fear of inflationary pressures combined with quickly rising rates spooked the market resulting in a quick 10% drop. Sometimes when these “jolts” occur, other risks that may not have been appreciated or at least properly priced are exposed. For example, in 2008, auction rate securities quickly illustrated a risk not appreciated by investors. In the brief but violent downturn experienced this February, the risk of being short volatility was exposed. While the initial downturn was due fears of increasing rates and inflationary pressures, it was exacerbated by a lack of prudence or at least respect for the short volatility trade – an exposure that kept on giving for the last two years before taking it all back and a lot more in a single day. It is helpful for investors to remember just how violent the markets move when dislocations occur allowing for a reassessment of their market exposure and incorporation of potential hedges.
Trailing Stops Create a Binary Decision Tree
Downside protection in a portfolio is a key need for many clients. Whether simply due to a conservative investor approaching retirement (e.g., 55 – 65+ group) or views that the market may be long in the tooth after one of the longest bull markets in the last century, a strategy that provides some hedge to a negative market has an important position in a portfolio allocation. Equally important in both scenarios provided is the behavioral need associated. Investors approaching retirement are at a sensitive point in their investing period as their nest egg is most likely at its largest size with withdrawals to fund lifestyle choices around the corner. Perception of a late in the cycle equity position may shake some out of the market prematurely. A strategy that provides the necessary hedge as well as a level of definition is key in maintaining positions in the market.
One of the most popular strategies within the industry is the buffered note, which provides 1st loss protection to a specified level with returns up to a maximum cap on a referenced market, such as the S&P 500. Historically, advisors have used the product in a number of ways, including:
- Core conservative equity position with satellite positions that are either more aggressive or conservative dependent on the client risk tolerance
- Partial replacement of fixed income given the low yield environment
- Replacement of alternative strategies such as market neutral, long-short and other hedge equity solutions that typically have less definition
In September 2014, Exceed partnered with Nasdaq in introducing a truly innovative approach to the structured notes market. With all material innovations, investors need the opportunity to kick the tires and understand how the product will actually work. Closing in on three years of live performance, we now have the opportunity to support some of the assertions provided early on with performance data.
As we leave 2016 behind and prepare for 2017, I wanted to share some of the themes we have recently been speaking and writing about. Over the last quarter, we penned four articles, appeared in three videos, and were quoted several times in additional articles.
Here are links to some of the aforementioned media spots:
The Benefits of Defined Outcome Investing, Nasdaq: A discussion on Exceed and the benefits of Defined Outcome investing
What is in Store for Markets in 2017, Voice of America: A read on VIX and what is in store for 2017 – one item discussed was whether VIX futures were pricing in too much complacency in the face of an elongated bull cycle and a new President with aims to disrupt existing political processes
Joe Halpern joined Jill Malandrino, Markets Reporter for the popular Voice of America segment on Nasdaq Facebook Live to discuss market volatility going into the national election and what may be in store come next week. Please listen in to learn what the VIX may be telling us.
Last week I penned an article in the November issue of Investment Advisor (a ThinkAdvisor publication); the article discusses how the VIX communicates expected volatility over the next 30 days.
Although VIX is always an important indicator to watch, in early 2016 it has provided particularly keen insights leading up to the Brexit vote and now is doing the same for the U.S. election cycle. As an FYI, VIX has jumped 50% in the last week (from 13 to 19), a sign of just how wild an election this is turning out to be. Interestingly, the VIX futures curve is partly in backwardation – both November and December expirations are closer to an 18 handle. This is communicating an expectation of higher volatility and uncertainty going into the election next week, with an expected lull in the action and hopefully more certainty thereafter.
Bradley Smith of Nasdaq interviewed Exceed’s CEO, Joseph Halpern, on Exceed and defined outcome investing
Low volatility funds have been hot, hot, hot – the top two domestic based ETFs in the category, USMV and SPLV, now have over $20 billion in assets between them, of which $8 billion has come in during the last six months (40% of total AUM).
At first glance, this popularity is understandable: the concept is straightforward and logical, the pitch is compelling, and risk-adjusted performance has been strong.
However, neither ETF has gone through a significant market correction, so a real concern is that investors do not have a good grip on the potential downside risk of these strategies. Thankfully, the indexes that both ETFs follow either existed or were backtested (Is a backtest trustworthy? Sometimes! Learn more) prior to 2008, providing a glimpse of how these strategies should have worked in a past downturn as well as a basis to analyze how they may act in future downturns.
I recently authored an article on retail investment returns which appears on the Nasdaq website. A longer version of the article is printed below:
My plan for driving to work is simple – follow Waze. I long ago came to the conclusion that Waze can see traffic patterns I can’t, and the smart thing to do is rely upon it.
Some days, however, I just ignore Waze and follow my own instincts for no apparent reason. I will rationalize this behavior – Waze can’t anticipate changing traffic patterns, Waze doesn’t know my shortcuts, and so forth. After I have finished that morning’s commute, I inevitably regret not having stuck to Waze and commit to following it going forward. Until I don’t the next time.
This pattern of having a plan, but being unable to resist fiddling with it, is a well-known and well- researched investor phenomenon. Investors historically try to outthink the system – selling to avoid losses when they (somehow) think they know a security is likely to decline, or jumping into a security when they (somehow) think they know it is likely to increase.
The amazing element of this investment pattern is how disastrous it consistently is – retail investors as an asset class have a horrendous track record vs. almost every other over the last 20 years.
Part one of a series of articles on product development
“I have never seen a bad backtest” is an often stated criticism of backtesting that has a high degree of truth to it – many strategies launch with strong backtests yet do not pan out as intended.
In truth, a well-designed backtest is a key tool among a number of tools that should be used for financial product manufacturers and asset managers to develop and vet investment strategies. Yet, many backtests have critical flaws inherent within them. Today, I will explore some of the general flaws frequently found in poorly designed backtests, as well as methods which a prospective investor can use to “kick the tires” on a backtest to separate the well designed from the flawed.
Check out our webinar on Beta vs. Delta.
Beta is one of the classic measurements within the financial industry. It is one of the first measurements shown on Yahoo Finance, right under the bid-ask and earnings estimate. Participants use it as a general gauge of market-related risk associated with an investment. As a reminder, an investment with a Beta of 0.8 is generally supposed to participate in 80% of a market move. So if the market increases 10% the investment should move up 8% and in a down 10% environment it should move down 8%. If only it was so simple…
Beta is so well known that most people have not reviewed the basics of its calculation in a while, nor do they remember its drawbacks – let’s do some Beta 101!
Beta is essentially the slope of the best fit line between the investment being studied (one axis of the graph) and the market (the other axis of the graph).
Market upheaval can be gut wrenching. The market can experience 5% and 10% declines with surprising frequency, with a typical bounce back relatively quickly. But once in a while you get a 2008 event where the market just continues to go down. Unfortunately, there is no way to identify which of those two market conditions an investor is in until after the fact.
These conflicting emotions certainly play into the documented reality that investors tend to exit markets at the wrong time – selling when they should be buying and vice versa.
Fortunately, there are solutions. A tangible floor on losses can go a long way to mitigating these realities – allowing for investor participation in the market with a safety net below.
Investors generally fear the unknown. Unfortunately, traditional market exposure is full of unknowns – market corrections occur without warning, with no telling how deep a drop or how long it will last. Exceed Investments offers a solution to this uncertainty – a controlled market exposure that mitigates downward surprises, titled defined outcome investing.
Defined outcome strategies use preset protection and return levels to shape a risk / reward exposure to a benchmark like the S&P 500. The strategy is proactive, rather than reactive – protection and return levels are set ahead of time, rather than in reaction to a particular market move.
Historically, these powerful strategies were only available to institutions and high net worth individuals through costly and illiquid instruments offered by banks. Exceed Investments is changing the investment landscape through providing the first accessible, transparent and liquid defined outcome strategies. Our strategies provide a defined, shaped exposure to the market within such traditional products as indexes, SMAs, and mutual funds. Our customers benefit from a controlled investment experience shaped to their preferred risk / reward exposure.
Joe Halpern discusses Defined Outcomes as well as general market commentary with Chuck Jaffe of the MoneyLife Talk Show
LISTEN TO THE INTERVIEW
The opinions of Joseph Halpern are as of the date of this interview, are subject to change and are not a predictor of future events. The materials presented here are not to be intended to be, nor should it be construed, as a recommendation, investment advice, an offer to sell or buy, a solicitation, or an endorsement of a particular product or investment strategy. Exceed Investments full disclosure is available here.
Financial innovation fuels a burgeoning mix of products whose performance characteristics investors often misunderstand. In response to the perennial threat of fee and margin compression, the industry is always looking for the next great strategy to offer customers, and competitors quickly copy new-fangled products as technology eases the delivery of investment services.
This constant innovation does create new ways for investors to reach their goals. But the profusion of choices has also exposed investors to product risks that become apparent only after the latest strategy collapses or the bubble bursts.
Consider, for example, the growing popularity of liquid alternatives. As 40 Act funds increasingly enter the territory once reserved for alternative funds and vehicles, many investors can now access liquid alt strategies––such as long/short, market neutral, and arbitrage––that had previously been available only to the privileged few. But as liquid alts and other complex strategies go mainstream, it’s critical that advisors understand how these products are designed and what can go wrong with them.
To illustrate the pitfalls of financial innovation unaccompanied by greater investor education, consider the following three examples of products that didn’t perform as expected.
Case Study #1: Leveraged ETFs
Leveraged ETFs are designed for short-term traders looking to increase specific exposures, and these ETFs can perform that function very efficiently. Problems arose when long-term retail investors started using leveraged ETF strategies to achieve long-term leveraged returns, an attractive proposition in a bull market.
In September 2014, Exceed Investments and the Nasdaq launched the first family of defined outcome indexes (Here’s our original blog post on the launch). The indexes allow investors to access defined outcome investments within a wide range of investment solutions, providing public markets with:
- Shaped exposures to the S&P 500, allowing investors to pre-define their preferred risk metrics and thereby experience a controlled investing experience
- Widespread access to strategies generally only available to institutions and ultra high net worth individuals via insurance or banked wrapped programs
- A liquid and diversified portfolio of securities that is regularly rebalanced
With one year of performance under our belt, it is worthwhile comparing how the indexes did vs. their objectives and the back testing we conducted on each of them. As expected, each index did what it was supposed to when it was supposed to; please take a look for yourself:
I recently came upon a Seeking Alpha article by Alliance Bernstein titled Structured Notes: Read the Fine Print. The article expressed a fairly negative and, in my opinion, inaccurate view of structured investing based on an analysis of one structured note in particular. As an experienced structurer and trader prior to founding Exceed Investments, I’d like to help set the record straight.
The article analyzes a 5-year 28% buffered note on the S&P 500 as an example. While they do not share a link to the terms, the note is similar to, if not exactly the same, as this note.
First, let’s briefly consider what a structured note is and discuss its purpose. Structured notes are an example of what I call “defined outcome” investments, which are options-based strategies that allow investors to shape a risk/ reward exposure to fit their personal objectives. In these strategies, market participation levels are preset. Therefore, the targeted downside participation is known in advance, as is the upside potential.
The unpredictable nature of the market can be terrifying. Any hint of volatility sends skittish investors in search of skilled managers to guide them through pending storms. But even when armed with a sound strategy, investors are vulnerable to fear of potential loss and could jump ship if doubt begins to seep in. That means managers must do more than just identify the right game plan. They must also consider investors’ confidence level in a strategy, and their willingness to ride it through the turmoil, to stop an exodus from the market.
We know from behavioral finance studies that investors feel the sting of loss more acutely than the thrill of gain. Recent reports indicate that the threatened loss of assets drove investors to squirrel away more money in cash allocations to protect from a downswing. Cash levels have increased to their highest point since the 2008 crisis at 5.5 percent of portfolios, according to the Bank of America Merrill Lynch Fund Manager Survey for July. That spike in risk aversion came amid weakening economic confidence in China, worries over Greek debt, and frustration over a low-interest-rate environment.
The investing world is slowly but surely getting a little scarier as flashpoints are adding to the unease of an already longer than typical bull market. Is there contagion from Greece? What is going on in China’s equity markets? And lets not forget Puerto Rico’s potential default.
Most investors have pressure to generate returns while simultaneously avoiding disasters. The problem is that without a crystal ball, the only way to generate returns is by taking on risk. There is simply no way around this. “High return, low risk” products brings out the skeptic in me – trust me, there is risk somewhere within the package that is applicable to the return. If the risk is not well understood or seems too good to be true it may be best to simply stay away.
I’m pleased to announce that I will be speaking at a Nasdaq-hosted Webinar titled “Optimizing Behavioral Economics Using Defined Outcome Investing”.
The webinar will cover various factors that influence investment decisions. While of course expected returns and risk play an obvious role, they don’t necessarily play the most important one — behavioral factors also heavily influence investor decisions. Learn more about behavioral economics, including what drives it, how it influences portfolio construction, and how using defined outcome solutions can meet both return and behavioral needs better than traditional investment solutions.
Joining me will be a representative from Nasdaq Global Indexes and Dr. Menachem Brenner, finance professor at the Leonard N. Stern School of Business at New York University and an international expert in derivative markets for a 60-minute web seminar where attendees will learn:
- What are behavioral responses to potential loss, risk, and ambiguity?
- How both human psychology and economic utility theory drive behavioral finance?
- How does behavioral finance influence investment decisions?
- What are defined outcome investments?
- How do defined outcome investments effectively balance investor returns and behavioral needs?
LISTEN NOW to the replay
Exceed Investment’s CEO, Joseph Halpern, published an article in Wealthmanagement.com on recent learnings from behavioral finance and how they can inform investment decisions.
The average investor defines and mitigates risk in ways that do not align neatly with classical financial theory. Deeply ingrained aversions to loss, risk and ambiguity often lead to investment decisions that clash with the imperative of maximizing risk-adjusted returns. Indeed, a growing body of research in behavioral finance confirms that cognitive biases can materially and adversely affect portfolio performance.
But no amount of research will transform how and why human investors make decisions. Ultimately, the typical investor wants more security, predictability and transparency than has traditionally been available in the marketplace. That unmet need results in a disconnect between portfolio performance optimization and investor behavior. A solution can be found in defined outcome investing strategies.
Follow this link to access the full white paper.
I recently had the opportunity to provide a “deconstructed note” column for one of Bloomberg’s periodicals – the Bloomberg Brief, April 30 2015 edition. In the article, I compare currency hedged ETFs to a popular structured note following a global basket of indexes and offering currency hedging. While content at Bloomberg Brief is typically behind a paywall, the editors at Bloomberg were kind enough to provide a link for our readers to access:
Guest Commentary: Favorable Forwards Make Currency-Hedged Notes Look Enticing
With market volatility picking up in recent months, coupled with a bull market that is now 6 years and running, a few themes have been top of mind with the investing community. I wanted to share a number of recent articles that I’ve published touching on some of these themes and the relevant role of defined outcome investing.
Wealthmanagement.com as well as Nasdaq published Beyond Active vs. Passive: A Third Way for Investors, an article in which I explore how the lines have blurred between active and passive investing, driven by the new wave of more sophisticated indexes that have recently hit the market. Defined outcome investing is one of those strategies. The use of rules-based defined outcomes to achieve Alpha provides an alternative to actively managed solutions. Traditionally, investors choose between Alpha-seeking active managers and passive rules-based solutions which deliver beta or some variation thereof. The prevailing wisdom is that in straight up markets passive is the way to go but when markets get choppy, active managers often outperform. Defined outcome investing provides a rules-based solution which can lead to successful market navigation regardless of clear or choppy conditions, with lower fees and less human subjectivity than traditional active management.
The other evening my wife and I had a couple over for dinner. Over the course of the evening we got to discussing what my company’s indexes, the Nasdaq Exceed index family, were created to do. My nine year old daughter piped up and said “explain your products in terms of cake and ice cream.” I decided to take on her challenge. I explained that imagine she had this delicious piece of cake and she was about to eat it but it fell on a dirty floor. With our product, I explained, you would lose a sliver of that cake but would still be able to eat a lot of it. However, in exchange for that protection, even if that cake did not fall, she would have to give up a little of the cake to protect it from calamity. While the adults around the table were impressed with the analogy, my daughter, less than satisfied, asked me what happened to the Ice Cream?!
The derivatives world has lost one of its biggest innovators and most important visionaries – Ivers Riley.
Ivers had a hand in almost every transformative moment involving listed equity derivatives since their inception in the 1970s. He played a key role in milestones as diverse as the approval of listed puts, the creation of the Options Clearing Corporation, the development of ETFs, and the advent of electronic trading. Investors the world over benefit from the high level of transparency and liquidity that his efforts put into motion over the last several decades.
The Kingda Ka roller coaster is one of the largest and perhaps scariest roller coasters in the world. After a fear invoking pause, it launches out of the gate, achieving a speed of 128 miles an hour in 3.5 seconds. It then goes 456 feet in the air before plummeting back down. Sounds like great fun for screaming teenagers (Alas, I’m past the age of appreciating the ride).
Airplane rides through turbulence also tend to shoot up and down, but they don’t seem to capture this same delight – more often than not, passengers are frequently annoyed and genuinely terrified.
One critical difference between a roller coaster and an airplane is how controlled the environment is. A roller coaster is a thrilling but controlled experience – as scary as it may seem, people know exactly where it starts and ends. In between those, riders get to shoot up and down and flip around in a safe environment.
An airplane ride is not a controlled environment. Turbulence is unpredictable and often uncontrollable, and there is always the small but real risk that the pilot really does lose control of the situation.
I recently came across a 7 year note offering 300% uncapped upside participation in the Goldman Sachs Momentum Builder Multi-Asset 5 ER Index (“The GS index”) with full principal protection. One of the best headline offerings you will ever see; to put it in perspective, a typical S&P note of the same duration would offer about 65% participation.
How can this note offer a return that is so compelling? As I have pointed out in prior blogs, there is no free lunch. Return is generally a function of risk, so there must be something more beneath the surface.
Let’s investigate the underlying index.
The GS index is a momentum-driven low volatility strategy that creates a basket of the best recent performers among a selected group of 14 ETFs across six asset classes. (The GS index is almost identical to the JP Morgan ETF Efficiente 5 Index, which has raised well over $1 billion in AUM since issuance. Recently, an ETF based on the Efficiente 10 index launched.)
I’m pleased to announce that I will be speaking at the Investment Management Consultants Association 2014 Winter Institute. This year’s event will take place on December 8th, 2014 in Phoenix, AZ.
My presentation, “Simplifying Complex Products and Concepts: Using Some of the Most Controversial Products in Favorable and Conservative Strategies”, will pull back the curtain on several complex products and discuss how traditionally “risky” investment products and features such as leverage, derivatives, and structured notes can be used responsibly to achieve some powerful investment results.
It promises to be a great conference. Please let me know if you plan on attending and if you’d like to get together to explore this topic further.
Introducing our first “Structured Notes Gone Wild” segment – the most interesting, unusual, or just wacky ideas we’ve come across. One of the compelling elements of structured investing is that design is only limited by the human imagination. Below, I highlight five of the most creative notes I have come across, two which were mentioned in a recent WSJ article by Jason Zweig.
2x – 3x Leverage Trigger Note
Characteristics: Investor receives 2x upside exposure to the common stock of Bank of America up to a cap of 18.10% unless the stock falls below 95% of its initial price during the first three months of the note, in which case the investor receives 3x leverage up to a 27.15% cap; full downside exposure.
I recently authored an article on structured note annuities which appears in the October 2014 issue of California Broker. They have graciously allowed me to it reprint here:
The structured note annuity (SNA) is a compelling and important offering that will profoundly affect the insurance complex. The flexibility of SNAs to match risk/return objectives opens the door to meeting a wide array of client needs that are not well met within existing annuity programs.
The launch of fixed indexed annuities (FIAs) in the 1990s was an innovation on a longstanding fixed annuity model. Owners could take a little risk on the yield in return for a higher potential payout. Using current pricing, a fixed annuity might offer a set 2% annual yield whereas an FIA would pay up to 3.5%, depending on market performance. Driven by the promise of greater upside, FIAs have grown to roughly $40 billion in annual issuance from their inception 20 years ago.
Fifteen years after the introduction of the FIA, a new annuity category was born: the structured note annuity (SNA). For brokers and clients alike, SNAs introduce increased flexibility to match risk/return objectives with an additional tool in the annuity product line. The insurance industry is increasing the level of risk in return for higher potential returns. Thus, while FIAs are limited to fully principal protected products and relatively modest caps, SNAs offer products with a defined level of principal at risk in exchange for higher profit potential.
Exceed CEO Joseph Halpern was quoted on index patenting in Money management executive.
In July we broached the topic of leverage in a post titled “5X Leverage – Sane or Insane?” For those wondering, the answer was sane – the note should outperform the Euro Stoxx index it tracks if 5-year annualized returns, inclusive of dividends, are between 1% and 12%. Since the historical 5 year annualized return for Euro Stoxx is approximately 8.5% (assuming a 2.5%-2.75% annual dividend), outperforming the index so long as the index is below 12% is compelling.
Today I would like to examine a different leveraged structured note that has attracted significant investor interest – 3X strategies on the S&P 500 have attracted well over $1 billion in notional this year. I will focus on eight notes (here’s the most recent one) struck roughly a month apart over the course of the first eight months of 2014, each with a notional of over $100 million.
As a Deconstructed Notes follower, you probably know my take on structured investing – the beauty lies in the limitless tailoring that can be applied to meet investor needs. On the flip side, the industry as it stands today is tainted with real and perceived issues, such as concentrated credit risk and concerns surrounding liquidity, transparency and cost.
The goal of my firm, Exceed Investments, is to develop next generation structured investments and strategies that offer the defined outcome benefits of structured notes while mitigating the issues they present to investors.
Today Exceed has announced the launch of a family of structured indexes in partnership with Nasdaq OMX. They are the first indexes of their kind, offering the benefits of defined outcomes within an index methodology. The Nasdaq Exceed family of Structured Indexes offer investors a controlled range of investment outcomes, all based on specific levels of protection and/or enhanced return that investors can select.
With Labor Day quickly approaching and summer coming to a close, it seems like an opportune time to provide an update on some of the prior stories we have featured.
One of the trends we have focused on are callable products. The reason we have tried to shine a light on this area is that structured call features tend to result in nice headlines featuring attractive long term appreciation potential, but in reality often result in returns or exposures which are less attractive for one reason or another.
In my last blog post I discussed leverage as a tool to outperform in certain market environments. The various investment options we reviewed were all focused on increasing or otherwise shaping the upside potential of structured investments. Now let’s take a look at another aspect of structured investing – the various tools available to protect against downside exposure.
Why are we interested?
When including dividends, the S&P 500 has returned roughly 125% over the prior 5 years despite sluggish domestic growth and political infighting in Washington. With the secular bull market now getting a bit long in the tooth by historical standards, investors may be looking for ways to continue participating in equity markets while adding a degree of protection to their investments.
While a number of investment products provide elements of protection (e.g., low vol funds), structured notes are one of the few products that can offer defined outcomes. Let’s analyze the characteristics and costs of some of the more popular protection-themed structured note offerings.
I have recently come across a few highly leveraged structured note offerings. One such note that caught my eye was a 5 year note offering 5x the upside performance of the popular Euro Stoxx 50 Index, up to a cap of 94%. The structured note offered no principal protection and exposed the investor to 1x downside exposure.
Why are we interested?
Leverage is a dirty word in securities investing, with good reason – margin investing is a risky enterprise unsuitable for most retail investors due to margin call potential, whereas leveraged ETFs provide the twin dangers of value decay due to daily compounding and leveraged downside.
In contrast, one of the benefits of structured investing is that leverage can be responsibly employed without the typical dangers. For starters, there are no margin calls to worry about. In addition, structured note leverage is not compounded daily, as leveraged ETFs are, but rather operates from inception to maturity. That means if the underlying index increases 10% over the 5 years to maturity, the issuer is obligated to pay out a 50% return (10% * 5x). Thus, there is no decay concern as is typically found in leveraged ETFs.
Furthermore, there is no leveraged downside in this particular investment – whereas it offers 5x upside, there is only 1x downside – not a bad tradeoff!
This morning Vertex Pharmaceutical (VRTX) announced positive results for phase 3 clinical trials. As a result, the stock soared 50%+ pre-market, surpassing $100 for the first time in the firm’s history. Of course, an unsuccessful outcome would have resulted in an extraordinary move in the opposite direction; clinical trial outcomes such as these present extreme binary events to investors.
In late February, 2014, a structured note was issued with roughly $20 Million in notional on VRTX. As I wrote in my blog post on binary events, this structured note presented investors with two unattractive outcomes – if the VRTX clinical trial was successful, the stock would appreciate significantly and the structured note would be called early and investor returns would be capped at a modest 5.5% yield (about 11% annualized). If the trial was unsuccessful, the stock would take a substantial hit, perhaps substantial enough to eliminate any principal protection and thus expose investors to a major loss.
Note in this document, structured investments are synonymous with structured products. Both refer to the class of products typically issued by banks to retail investors with such customized features as principal protection and leverage.
(New York, June 19, 2014) – In a survey of 700 financial advisors, Exceed Investments found that perceived and structural inefficiencies were holding back latent demand for structured investments with 20 percent of all respondents saying they would sell considerably more structured products if liquidity and transparency were improved. Furthermore, 20 percent of RIAs said they would like to sell structured products to at least some of their clients but don’t have access to the product.
The survey also explored motivations driving the usage of structured products, finding that 80 percent of respondents cited protection against index declines as the most compelling structured feature. Along similar lines, 60 percent of active structured product users identified the ability to customize risk/reward tradeoffs as the main driver of their usage.
For those of you attending this years North American Structured Products Conference, I’ll be participating in a roundtable discussion “What Do Buy-Side Clients Really Want?” Joining me will be Eric Glicksman, Managing Director and Head, Structured Solutions for UBS in the Americas and Deryk Rhodes, Executive Director, Structured Products Trading at InCapital LLC. Discussion topics include:
- Distribution of structured products for private banks, institutional, and retail clients
- What products are flourishing as investors move to “risk-on”
- Secondary market pricing
- The role of structured products in retirement solutions
It promises to be a great discussion and conference.
The conference takes place at the Seaport Hotel in Boston on June 26th and 27th, with the roundtable discussion on Thursday the 26th at 2:20PM.
Additional details can be found on the conference website
This past week I came across an interesting survey conducted by Russell Investments on Smart Beta indexes.
For starters, what is “Smart Beta”? That can depend on who you ask; the consensus definition in this survey was “Alternative ways to construct market exposures such as minimum variance, fundamental weighting, maximum diversification, equal risk, or equal weighted”.
Why are We Interested?
One of the key findings of the survey is the “greatest unmet [investor] need is for smart beta indices that control exposures.”
While survey designers focused on Smart Beta funds as a means to solve this unmet need, let me propose another: Structured notes! Structured notes can be easily used to control unwanted exposures, and at times to introduce new ones.
Structured Note Annuities (SNAs) are a relatively new retirement product within the insurance complex; they are poised to become a breakout product due to their ability to provide defined exposures for investors, similar to bank issued structured notes, while minimizing basis risk for insurers.
I recently co-authored an in-depth article on SNAs which appears as the cover story for the April/May 2014 issue of The Actuary, the magazine of the Society of Actuaries. (The Society is the largest professional organization of its kind in the US, serving 23,000 members). Some highlights of the article include:
Imagine you purchase Apple stock. By definition, you and the seller are on opposites sides of a binary trade – if Apple zooms up, you will have made money and the seller will presumably regret selling, and vice versa. Apple is most likely going to move one way or the other, so there’s going to be a winner and a loser.
Do structured notes present a similar binary outcome between buyer and seller? If the investing purchaser makes money, does the issuing bank lose money? And vice versa? The answer is a resounding no!
Why Are We Interested?
Purchasers of structured notes sometimes believe the issuer automatically wins when they lose, which would place a bank in conflict with their clients. The short answer is that this is not the case. The outcome is not a zero-sum game, and ultimately both the investor and bank can win. It is in an issuer’s best interest for the client to win in the long run as this would lead to an increase in both business and revenue – so yes, trading desks (mostly) root for the client. In this post, we will discuss the makeup of a structured note and how the trader at the issuing bank treats the product very differently than the client, resulting in a potential win-win situation.
A recent structured note caught my attention because it a) offered great characteristics and b) was based on an underlying biotechnology stock. These characteristics suggest that note performance may be tied to an upcoming binary, highly volatile event Did investors pick up on this prior to putting $20M notional into this note and do they understand the implications as relates to the note?
Why are we interested?
Binary outcomes make for complex and interesting analyses. Today’s blog will focus on options and notes referencing stocks whose performance is subject to binary outcomes (e.g., Biotech companies facing drug trial results, companies with upcoming major litigation decisions, and so on); these investments require a very different kind of analysis than your everyday stock, so investors should tread carefully.
An advisor recently asked me to evaluate a structured CD he was considering; the market linked CD paid a variable coupon derived by the performance of a basket of 10 stocks.
Why are we interested?
For this particular investment, the correlation between the 10 stocks has an outsized impact on total returns; in fact, it is impossible to effectively evaluate this investment without analyzing the correlation among the securities in the basket. My goal today is to define correlation and show its effects on everything from investments to the NBA draft.
One of my favorite advertising slogans from childhood was the Wendy’s “where’s the beef?” question regarding competitor (i.e., McDonalds and Burger King) hamburgers.
I often hear a similar question regarding structured notes – “where’s the dividend?” A key difference between structured note investments and more traditional securities is the lack of a dividend in most structured notes. For example, a note linked to SPY (the S&P 500 ETF) will not necessarily pay out any yield or dividend despite the fact that SPY itself does pay out a dividend. This disparity results in an assumption by some investors that the issuers “pocket” the missing dividend and thereby deprive investors. This is simply not true – the dividend, or lack thereof, is taken into account when creating and pricing a structured note. Today we will explore just how the reference security’s dividend does get utilized in the pricing of a structured note as well as in OTC and listed options.
Happy 2014! In the spirit of New Year’s resolutions, we thought this would be an opportune time to help investors reduce risk by developing a checklist template specifically crafted for structured note investments.
As I hope you know from reading this blog, I am a strong believer in structured products. They are customizable instruments that empower investors to achieve all sorts of investment objectives that are difficult, if not impossible, to replicate through other means. I am also a big proponent of investor education, especially as relates to structured notes, because they tend to be complex, are often misunderstood, and are not always the best means of achieving an investors goals. In that spirit, I have developed the following Structured Notes Investor Checklist. It includes important questions that every investor should address carefully before purchasing a structured note. As always, I look forward to your feedback and comments.
An advisor has requested my opinion on a Step-Up Callable CD, which I was keen to consider as it relates well to two of our recent discussions on tapering and callable notes. There is no link to the CD we are analyzing as they are not filed in a similar fashion to structured notes.
Why are we interested?
Structured CDs have become very popular over the last few years. While there is no effective way to tally the annual notional issuance of Structured CDs, I have heard estimates of $25 – $40 billion– a large segment of the market worth exploring. Driving this growth are two dynamics: 1) investors pulling back from risk and 2) the low interest rate environment. Theoretically in a Structured CD, the CD component addresses risk concerns while the structuring enables an increase in yields. However, as I have discussed previously, a callable feature can often be a costly element for an investor — and structures that make use of them often aren’t as attractive as they appear at first. In today’s Deconstructed Notes, I will revisit the question of whether the extra initial yield paid by the issuer in exchange for the call provision is worth it.
Given all the attention on whether (or when) the Fed will taper, we found two notes that should generate positive returns if (when) tapering begins.
Why are we interested?
The “conventional wisdom” is that rates will move up, it’s only a question of when. The structured notes we are looking at today provide equally interesting but very different ways to make a bet on a rate increase, while providing a level of protection to the investor if rates decline.
This week we look at the specific advantages of structured products as a way to customize a stock purchase.
Why are we interested?
Ford revolutionized the car industry with the introduction of the Model T. It was the first real standardized car. Based on the pictures, they all came in black. Forget about customizing…I don’t think you could even choose a color! Fast forward to today and you can buy a Ford or any other car in multiple colors, choose your wheel size (and cool rims), add all sorts of systems, and so on. The car has both mass customization (packaged add-ons) and more specialized customization. In today’s Deconstructed Notes, we will analyze how structured products can offer a user-friendly experience along with precise customization capabilities when purchasing an investment strategy.
This week we examine callable structured notes. Our representative note and its terms can be found here.
Why are we interested?
Notes with a call feature typically offer very attractive “headline” yields, but these structures often aren’t as attractive as they may first appear. Generally, they are worth significantly less than a non-callable note with the same features and yield. In today’s Deconstructed Notes, we will demonstrate why the analyzed callable note that legitimately markets a 15% annual yield is in fact economically equivalent to a 7.35% yield when not callable. A call feature enables a higher “headline” yield because it introduces a chance that the higher yield is not paid; generally, the probability-weighted interest cost to the issuer is the same as a non-callable note.
Exceed Investments performed a series of additional analyses on the raw data gathered by WealthManagement.com for our commissioned study, Viability Study: Exchange Traded Structured Products. Exchange Traded Strategies, Winter 2013. The findings from our supplemental analyses are in this report, Viability Study: Supplement, Winter 2013.
This week we examine a complex structured product masquerading as a straightforward yield note. Our representative note and its terms can be found here.
The name of the note on the term sheet is:
8% Equity Linked Securities due August 6, 2014
Linked to the Common Stock of Halliburton Company
Why are we interested?
Have you ever signed up for a cell phone plan offered at $50 per month but discovered that the bill you received was far higher (e.g., access charges, federal excise tax, universal service charges)? Apparently, you didn’t read all the fine print… More…
In the first quarter of 2013, Exceed Investments commissioned a study by WealthManagement.com, a Penton Media company, to measure advisor interest in distributing ETS.
Findings from that study are published in this report, Viability Study: Exchange Traded Structured Products. Exchange Traded Strategies, Winter 2013.