Indexing the index products!

Unsurprisingly, the investment industry is all about benchmarks. A mix of science, psychology and of course emotion form the backdrop to the rise of the index in today’s investment environment. Beyond that, regardless of the measurement, an effort has been made to index all sorts of things- such as climate indices, pollution indices, educational indices – let’s face it benchmarks have been proliferating since the Magna Carta, and it is now at an all time high!

Up to now, however, structured products have been excluded from the index club in the UK, which is especially ironic given how many are based on indices. This can’t have helped an asset type that has already suffered from accusations of opacity and complexity.

This is about to change with the launch of the UK Autocall Index, the debut benchmark from CUBE investing and Investment Product Research.

The index charts the day-to-day change in the price of UK equity-linked auto-calls, allowing the performance of the most common and popular type of structured product to be compared with other indices and assets.

To be included in the Index, products must be linked to the FTSE 100. There needs to be a kick-out feature every year at a minimum from the first or second year. The product must be available to retail investors, and there has to be a daily price. If a product meets these requirements then it is included. The lack of any public information about the sales of individual products means each product is equally weighted in the index.

The index has been calculated with a base price of 1000 at the beginning of 2013. This date has been chosen to coincide with the introduction of RDR. Products launched after this date would not have any adviser commission built into the product terms, and so the performance of the index can be compared with other assets like funds and ETFs.

The fact that most retail products are offered as ‘plans’, which include the costs of brokerage, administration and custody, dampens the performance of the index. A true like-for-like comparison should look at the costs incurred buying a fund but this would require a lot of imprecise estimation and costs can vary considerably between funds.

So now we have an index of these products, what does it look like?

The initial results support the widespread perception that auto-calls offer steady performance with less volatility in normal market conditions than an equity fund. The benchmark for the analysis is the total return of the iShare fund that tracks the FTSE 100.

Over the last 12 months, the Auto-call index is up 3.6% versus the iShare that is up 5.0%. However, return is only half the story, as risk needs to also be taken account. When we look at risk, the Auto-call index has a volatility of 7% and so a Sharpe Ratio of 0.47. The iShare has a volatility of 12.0% and so a Sharpe ratio of 0.39. So overall the Auto-call Index shows that these products have delivered a marginally better risk/return than the iShare.

The fact that the Sharpe Ratio is similar to the FTSE iShare should comfort investors. Those accusing structured products of being too ‘risky’ for investors need to question this assumption. There is no magic formula and risk is related to returns. Investors in auto-calls are aware they have accepted some downside risk, and that their returns are capped but know that they have a high probability of earning a very attractive return.

Looking forward, Cube Investing expects to see:

- If markets continue to make new highs, the Auto-call index will rise as well and offer even more attractive returns, but because returns are sometimes capped, the performance of the index may lag the underlying index

- If markets remain stable, auto-calls can be expected to offer higher returns than an index tracker

- If markets fall, the auto-call index will fall as well, but will be more defensive than the iShare as a result of the embedded market protection in the products

- If there is a large and sudden drop in the level of the index, the level of the Auto-call Index may fall significantly as well. Look at previous crisis points, the impact of falling markets and increased volatility is exaggerated if CDS levels increase.

Now that we have this index, it becomes possible to see what has happened, and to examine the risk and return in aggregate and compare auto-calls to other investments.

The views expressed in this article are those of the author and do not necessarily represent those of StructuredProductReview.com.