In this scenario, persuading clients to invest new money when considerable uncertainty remains can be difficult. Yet interest rates are not going to increase rapidly any time soon and mutual fund trackers are almost certainly going to be off the menu, which means investors are going to have to face investment risk.
For many that may not be a very palatable option. Which is where defensive strategy structured products can be used to help balance new investment money so the client can feel more comfortable with their overall investment decision.
Defensive products offer the investor the potential to achieve a positive return on their investment even if the market has fallen. Invariably, they also offer capital protection unless the index against which they are benchmarked has fallen by more than 50% (which in anyone’s book is a severe market event).
Typically these are autocall investments, meaning that although having five- or six-year terms, they offer the potential for an earlier payout if certain criteria have been met. Let’s take as an example, a six-year non defensive product offering an 8% return each year with a maximum payout in year 6 of 48% return.
What determines the payout is the level of the index in comparison to when the investment struck/started.
If at the plan’s one year anniversary the index is at or higher than the strike level, then the plan pays out 8% and closes. If the index is lower, the investment rolls over and the plan might pay out 16% in year two, 24% in year three through to 48% in year 6, depending on where the index is at each anniversary point.
The autocall facility enables financial advisers and investors to take a view on the market – for example, that it will track sideways, will be subject to possible extreme fluctuations, but this could be just a one- or two-year phenomenon – and use the plan as a potential short-term investment pending the markets rising in any substantial way, or as a means to protect capital against short-term index falls.
Defensive strategies take this one step further and pay out a positive return if the index is down a set percentage – for example, 5% or 10% or 25% of the initial level.
It may be that the market falls and stays below its current level for the full six years, in which case the investor receives back their investment and so does not lose any of their original capital. This is likely to have been eroded by inflation but not by the percentage fall in the market. Likewise, the market could fall more than 50%, in which case capital would be lost on a 1:1 basis with the percentage fall in the index.
It could be that the market does in fact race away making an 8% gain over one year look derisory, but of course that comes back to the function of risk and return.
There is also credit risk to factor in – whether the institution acting as counterparty to the investment, usually a bank, will be solvent in one to six years in order to pay back the capital and pay out the return.
There have been several defensive products launched in the market recently, offering a range of options. For example, one offers an 11.75% gain on the net investment for every year held, payable from year two onwards, provided the FTSE 100 and Euro Stoxx 50 close no more than 5% below their strike points at the anniversary date.
Another product offers 9% gain on the net investment for every year held, payable from year two onwards, provided the FTSE 100 closes no more than 10% below the plan’s strike point.
And a further example has the potential for an 8% gain on the net investment for every year held, payable from year two onwards, provided the FTSE 100 and S&P 500 close at or above their strike points but, should the market stay below the strike level for the full six-year term, will pay out the full 48% return as long as those indices are above 75% of their initial strike levels.
Using autocall structured investments, a client’s investment could be divided and balanced between defensive autocalls to give the potential for a fixed return as well as some capital protection and actively managed funds to capture any significant uplift should that occur.
Add defensive autocalls to the mix and this would give the client the confidence of knowing that if the market falls, except in a severe market downturn, at least the structured element of their overall investment would be returned at maturity and they could even achieve a positive return out of negative markets. This should also make investing the remainder of their cash in actively managed funds or similar investments a more palatable risk to accept.