Three Years of Innovation: The Rolling Buffered Notes
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.
The index analyzed today is our Nasdaq Exceed Defined Hedge Index (EXHEDG) of which we recently launched a mutual fund in partnership with Catalyst Funds – Click here for the announcement and here for more information on the Fund and Catalyst. EXHEDG is essentially a laddered, rolling buffered note strategy based on the S&P 500. For those not as familiar, the objective of a buffered note is to protect on first losses while providing a return up to a specific cap. The protection on the downside is financed by limiting the upside.
The following graphs illustrate a hypothetical 1 year buffered note on the S&P 500 with a 10% buffer and 150% participation up to a cap. The first graph illustrates the expected return at maturity of the note as compared to the S&P 500 index. The second graph illustrates the expected return of the 1 year buffered note based on a few distinct results for the S&P 500 index.
The buffered strategy is extremely popular with issuance in the billions annually, through either bank issued notes or insurance issued variable indexed annuities like the AXA Structured Capital Strategies program. The benefits of the product is the high level of definition and therefore confidence in the expected return. This benefit should not be overlooked as most strategies have a hard time providing this sort of definition, especially when a hedge is being offered, resulting in many strategies promising performance over a market cycle, a terribly long period in today’s fast paced and short term, results oriented environment. A structured note uses options to contractually lock in this definition, so lacking a default by the issuer (which we will get to), the expected outcome should occur.
Now there are a few detriments to the product as provided by the traditional issuer, some of which are detailed below:
- Lack of liquidity: Exiting a note early will cost the investor due upfront fees and additional spreads typically assessed by the issuer. A Variable Annuity is a long term contract with material fees for exiting early and limited availability of alternative strategies on the current variable index annuity platforms.
- Concentrated credit risk: A note is a senior unsecured debt obligation of the issuer (i.e., an IOU). If the issuer goes bankrupt, as was the case with Lehman Brothers, the owner gets a fraction of the notes value back.
- General complexity: Beyond a lack of standardization in the industry making it at times hard to analyze exactly what the exposure is, there are potentially high minimums, high costs, access issues, implementation issues, and a general lack of transparency.
These are all either solved or materially improved through our approach as follows:
- Liquid: A mutual fund structure allows entering and exiting at a daily net asset value (NAV). Furthermore, as will be seen, off-the-shelf, liquid securities are used in place of traditional over the counter, bank created securities which should allow for a more competitive, liquid environment.
- Mitigated Credit Risk: Our strategy tracks a portfolio of short term investment grade bonds allowing for mitigated, diversified credit risk.
- Standardized: A consistency unmet by the current industry in regards market exposure, low minimums, access and fees via a mutual fund structure and high levels of transparency due the index and associated product.
Furthermore, by laddering and rolling a portfolio of buffered strategies, similar to the way a bond fund ladders and rolls a particular bond strategy, a number of other improvements are provided, namely:
- Easy implementation within a model portfolio
- Diversification of market entry and exit
- Managed approach to laddering a portfolio
With the advantage of transparency as well as the perpetual nature of the product, we can now review how these products actually work in the market – note that the index has been continuously calculated by a third party and disseminated by Nasdaq since September 2014.
The index is made up of four series, each a replication of a traditional structured note. The strategy uses listed S&P based options rather than over-the-counter (OTC) options and publicly issued, Investment Grade credit securities (IG Bonds) rather than private bank issued senior, unsecured notes in replicating the traditional structured note.
The strategy then ladders the replicated notes quarterly and rolls them at maturity. The result is that performance is similar but with materially enhanced characteristics as reviewed above.
Let’s first focus on the individual series prior to graduating to the index in order to provide a complete review.
Between the different underlying products placed within a structured note and some complexity due the option component and a lack of general transparency in the industry there is sometimes confusion over how a structured note is expected to perform over time. Graph 1 illustrates the expected outcome at maturity based on the price action of the underlying security. The orange line reflects actual SPY price movement over a specific series within the index – October 2014 through November 2015.
Graph 1: SPY vs expected outcome at maturity assuming 1.5x leverage and a 13% cap
Now neither a structured note nor our series, both which moves in a very similar fashion, moves based on the concluding characteristics. In reality it lags in both directions as will be explained below. Graph 2 shows actual series performance in blue over the time period.
Graph 2: Graph 1 + actual series/structured note performance
To recap, the expected performance at maturity is the gray line while the actual fair value of the series is reflected by the blue line, pointing to a material difference in the beginning of the term that aligns by the end of the term. Due to upfront fees and market spreads, a structured note and variable indexed annuity would expect to have an even lower value than reflected by the blue line early on.
The reason for the material underperformance as compared to the ultimate payout is due the optionality of the option positions. Let’s focus on the put position of a buffered strategy to illustrate this. A put provides the “option” to the put owner to sell the underlying security at the strike level (i.e., “put” the stock to the seller). A buffered strategy sells a put 10% out of the money. So if the S&P is trading at 2,400, the strategy sells a put with a strike price of 2,160. As long as the S&P 500 closes above 2,160 on maturity of the put, the put will expire worthless, which is what the put seller wants. If the S&P 500 is below the strike of 2,160, the put seller will begin to suffer losses as illustrated by the following graph.
Graph 3: Short Put Payout at Maturity
Graph 4: Put leg of the structured note series
One can think of the Put as market insurance with the seller playing the part of the insurance issuer and the purchaser of the put playing the part of customer. On day one, the Put, as illustrated above, was sold at $9.49. That means, for the risk that the market does decline by more than 10% over the next year, the cost is $9.49 or the equivalent of 5%. Now if the market proceeds to increase by close to 10% over a period of 1 month as occurred in the market in the period analyzed, the put does not become worthless. The graph above illustrates that the put actually decreased about 55% to $4, contributing around 2.75% to the structured note series. As duration of the series decreased, the put accreted towards a value of $0 as the S&P never came close to piercing the strike level of the put. Interestingly enough, in early fall 2015, the market dropped about 10% and then hit roughly the same low a month apart as can be seen in the last chart above. The Put picked up value both times but, with the market still close to 10% away from the put strike and time dwindling away, the second instance resulted in a much lesser pop in the put value – this is purely due to time value.
Simply stated, there will always be a premium associated with an option as long as there is a statistical chance that by maturity the option will be worth something. And due to this reality, the actual value does not tend to reflect the payout at maturity until late in the term or potentially at maturity.
As can be seen in the second area highlighted of graph 2, as time goes on, given a flat market, the strategy would expect to accrete towards the expected value. And by the end of the term, as exhibited in the third highlighted area, the series level inevitably accretes towards the strategy characteristics at maturity.
Expectations should be similar in a downturn but in reverse. Following is the next two series from the index. As can be seen, the market declined towards the end of the cycle in the first graph and in the middle for the second graph. Note that in the first graph the negative return was relatively muted towards the end of the series as compared to the second downturn in the second graph. This is purely a function of the time remaining in the series prior to maturity.
Graph 5: Series 2 of the index
Graph 6: Series 3 of the index
Let us now turn our attention to annual expected returns. As can be seen from the graphs above, each series generates returns that align with expectations. There is a slight variance due the fixed income portfolio which will result in slightly higher or lower gains but again, it will be pretty close.
However, the strategy uses a rolling, laddered portfolio. This is akin to an investor going from buying single bonds to buying a portfolio of laddered, rolling bonds (e.g., a short term investment grade mutual fund like CSJ or SCPB as compared to selecting one’s self). In the single bond instance, the investor has a higher level of certainty but no diversification. If there is a default they will lose most of his investment. An investor is also not diversified in regards market entry/exit. In the laddered, rolling portfolio there is a little less certainty but still a good idea of outcome and is diversified in regards credit risk and market entry/exit risk. Furthermore, if that investor was now an advisor, the portfolio is significantly easier to implement and manage within model portfolios as well as a portfolio of clients as compared to single bonds.
Exceed is providing the portfolio approach to the structured notes market. Based on our roughly three years of performance, the outcome is relatively similar to what one would expect buying a single note at any point in time. Looking at the three series reviewed above but now adding the index performance to the graph, one can see that index performance is rather aligned.
Graph 7: Series 1 with index performance
Graph 8: Series 2 with index performance
Graph 9: Series 3 with index performance
As can be seen, in certain instances the index will do a bit better and others a bit worse. The index is essentially the average of the four series resulting in even lower volatility than a traditional structured note. Performance of the index strategy will run at a discount or premium to a particular index strategy based on how the particular series performs. This highlights the diversification of market entry/exit provided by the strategy as outliers, both good and bad, are muted.
When applying performance on an annualized basis as opposed to one distinct point, once again the laddered, rolling approach illustrates that it performs as expected. The following graph illustrates one year performance for every date since inception.
Graph 10: One year rolling performance since inception through May 2017
As can be seen, in market declines, the strategy provides approximately a 10% buffer. In moderate markets, the strategy provides a bit of outperformance and in strong markets it will underperform yet still provide a nice return in the high single, low double digits. When yields and/or volatility pick up, which presumably it will, then caps would expect to rise. As the index rebalances, it would rebalance into these higher caps.
Furthermore, now that there is a performance history, other statistics that were harder to tease out of traditional structured notes can now be presented. For example, over the period in question, we can now see that the strategy generates a significantly lower volatility profile due to some of what had been discussed earlier.
Graph 11: One year rolling volatility since inception through May 2017
In conclusion, we would like to believe we have ushered in the next phase of structured note industry growth and usage. A standardized approach to a consistent S&P 500 exposure on one of the most popular strategies in the market allows for applications not available with the traditional structured note or variable annuity. The strategy is now easily applied to model portfolios as well as wrap accounts. The strategy can be used as a portfolio’s foundation with other structured notes serving as satellite positions entered into advantageously based on market actions. Perhaps most importantly, the strategy can now more easily be compared to other mutual fund strategies in the market place and used competitively in place of those.