Structured Deposits: The way towards Asymmetric Returns

The current investment climate: an investor’s perspective

The last three years have been characterised by a critical market situation both in terms of returns and extreme volatility. The general assumption that diversification reduces the overall risk didn’t ring true during the peak of the crisis when all asset classes fell at the same time.

During this period long-term savings were eroded dramatically, particularly when the effect of inflation is also taken into account.

It is still a widely held belief amongst investors that the stock market should provide a no-lose solution in the long-term. They have got used to this idea whilst living in a period of quasi-permanent growth and relative peace in the developed world, which has helped to sustain the view that companies could grow in an almost continuous way, enjoying permanent increases in their earnings year after year. Individual investors expected to receive double digit returns on a periodic basis. Unfortunately, the experience of the past few years has forced these assumptions to be re-evaluated and the focus is now on a more realistic view where we must weigh up the different options.

An initial response to the recession was the development of alternative methods of investing, notably within the hedge fund industry and by fund managers that specialised in generating absolute returns independent of stock market movements. This approach, which had proved very efficient in the past, was quickly overcrowded by new entrants in the market and with these new participants the existing opportunities started to disappear. The same strategies that provided impressive returns in the 90s were quickly turning to poor performance and certainly not something that could compete or justify the level of fees originally designed during the golden years. These managers were trying to achieve, through a very active management style, a return that could mimic the stock market in the good times but avoid the downfalls during the bad ones. The number of techniques and strategies employed ranged from the simplest approaches to the most sophisticated black boxes. But, as shown in the table, the results have not been good enough, even if they showed better returns than the overall stock market, and with less volatility, the total annual returns have not provided a solution unless they were combined with other investing strategies.

Click Here for Figure 1.

What is the investor looking for?

After the economic downturns of the last decade, investors are now increasingly looking for safety (and this includes liquidity). Returns are no longer the main motivation and this explains how, in an historic low interest rate environment, the appetite for other assets that could carry more risk but higher returns has been much lower. Of course there are some exceptions to this, but largely for tactical reasons as in the case of crude oil, or as a safe haven in the case of gold, although even here, in the specific case of gold there has recently been a volatility that does not fit well with the definition of a safe asset given the high correlation with the fall in the stock markets in September. It is surprising when you look back and compare the yield offered by money market funds or by term deposits only a couple of years ago with what is on offer today. What is most interesting is the fact that there is still a huge appetite for those kind of assets and this indicates that people are prepared to accept a comparatively low return in exchange for safety. Alternative investments and the stock markets (as shown in the Table) have proved to be less successful than they were supposed to be.

A quick look at the FTSE All Share during the last 10 years (as shown in Graph) clearly indicates that the excellent performance of some years is followed by a period of dramatic losses and the consecutive cycles of boom and bust are very evident when plotting a long term graph highlighting why this new appetite for lower risk investing has emerged.

Click Here for Figure 2.

This high volatility, together with low performance, has made people wary of the stock market until the prevailing conditions revert to the norm. Here the problem is knowing what is now normal and how long it will be before the market can be considered such.

Essentially, advisers and investors now have their interests aligned and they are worried about three key aspects when investing:

• Lack of diversification
• Low return environment
• High volatility.

The answer from the industry

It has been difficult to find attractive returns in the current market. An increase of very active asset management approaches available for HNW and mass affluent customers occurred, but again the space available for hedge fund strategies proved to be limited and most of them didn’t pay what the public was expecting. They generated better returns than the stock market in general (based on the data in the Table above) but they did not deliver the all weather investment solution that was expected.

Another development has been the creation of more and more thematic funds that behave well in specific market situations but lack the historical track record to show that the correlation with other assets will not be high under a stress scenario. A proof of this is the recent appetite for emerging markets or natural resources and commodities funds. 

Asymmetric returns: the search for playing safely

When we talk about asymmetric returns we are talking about investment strategies whose returns are linked to the stock market but are not an exact mirror of what the stock market does. It defines an investment that participates in all or part of the upside but where no capital is lost if things go wrong with the underlying index, commodity or equity to which the plan is linked.

The main concern at this stage of the investment cycle issafety. We have therefore developed a range of structured deposit solutions to meet this need, linked to the FTSE 100 Index they deliver easy to understand pay offs that will fulfil different investor needs enabling the investor to profit from any upside but keep their initial investment safe just in case.

 The purpose of this approach is to:

• Diversify the client portfolio, lowering the correlation between the different investments held - especially in distressed times when correlations get closer amongst investments thus jeopardising the benefits of diversification
• Potentially provide enhanced returns over cash with 100% capital protection at maturity, although less than 100% of capital may be payable if withdrawn prior to maturity
• Lower the volatility of a portfolio, allowing the client to have less uncertainty and a better idea of how their portfolio is due to perform, thereby reducing planning issues.

Next steps for structured deposit providers

It is essential that the main providers and manufacturers of these types of products establish an open and continuous dialogue with advisory teams and distributors so that their main concerns surrounding these protected investments are resolved. Some of the key existing concerns are:

• How the product works?
• How are all the components put in place?
• A clear explanation of all the costs and risks involved
• Benefits to which, otherwise, the client will not have access: wholesale funding, long-term bespoke options, liquidity
• Exit strategies and worst case scenarios (i.e. FSCS in the case of deposits)
• Which part of the client portfolio are these investments going to replace?

It is necessary to eradicate the idea that these investments are the creation of a financial alchemist and instead put them into a context they can be compared with all the other investment options available, allowing all the pros and cons to be viewed in a sensible and objective way.

The role of the adviser is essential to help clients create a well balanced an diversified portfolio, and structured deposits can play an important part in this, especially for risk averse investors.