One of the more significant impacts of the UK’s retail distribution review was the adoption of model and managed portfolios by financial advisers. While broadly positive, this trend has, over time, led to asset allocation becoming more stylised and less flexible than it once was.
Today, most benchmark model portfolios define the percentage exposure to a set of asset class buckets. For the most part, these are commonly accepted asset classes like UK equity, US equity, government bonds and high yield bonds. The main job for portfolio managers is then to identify the best fund for each bucket.
Many managers sensibly stick to these prescribed buckets, as doing so makes the whole process smoother and easier. But are benchmark models giving managers too little flexibility to decide what they invest in?
The Opportunity Cost
The key issue is that funds and products that do not fall into the asset class categories will not be considered for selection, as they sit outside the model.
One example is structured products. By design, structured products offer an asymmetric return profile that can be hard to categorise in a binary world of equities and bonds. For instance, in normal market conditions, structured products have a high probability of delivering the headline return, and so look like a bond. In a stressed market, however, their mark-to-market value can fall, so they look like equities. Simultaneously, the high conditional correlation in stressed markets makes structured products appear ill-suited to the “alternative” bucket. As a result, they are rarely used in model portfolios. While this may make operational sense, from an investment perspective it is a missed opportunity.
In theory at least, structured products offer a range of benefits that should appeal to many investors. These include high returns that are not contingent on rising markets, a lower chance of loss (due to downside protection) and defined returns, which can reduce ambiguity about the end result.
Indeed, the payoffs structured products offer is similar to other assets that do get categorised as equities or bonds. Take fixed income. Funds that invest in bonds issued by companies and emerging market governments offer the same return profile as structured products. Most corporate bonds are likely to lose value in stressed market conditions. High-yield bonds, leasing, loans, asset-backed assets and additional tier one bonds all have increased correlation to equity when equity values fall, but are classified as bonds. In equities, funds that use covered calls have a similar pay-off to structured products but are classed as equity funds.
But Why Does That Matter?
In our view, there is a significant opportunity cost to not including structured products in portfolios. Indices of structured product returns, and the performance of structured funds, illustrate the attractive risk/return profile. Structured products will lose value when markets fall, but they tend to recover more quickly as well.
Looking at FTSE-linked structured products, we can see projected returns for 2022 are 9.7%, which look exceptionally attractive given the prevailing view that equity markets are not likely to be as buoyant in 2022 as they were last year. Some of these products will return even if the index falls by 10%. The ones that do not return will roll over instead. In 2022, the pace of maturities looks set to increase through the year, with higher payoffs as well.
A Place in Portfolios
If the risk/return profile is attractive, the key question is: where do structured products sit in a portfolio?
Structured products can be used as part of the equity allocation to provide a boost to returns when returns are below average. They can act as a replacement for corporate bonds when the credit risk premium is low, while also reducing the exposure to individual credit defaults. Alternatively, they can be used in the alternatives basket, where funds can be ambiguous, complex and illiquid, and ultimately still carry latent equity risk.
The current approach to model portfolio benchmarking does not lend itself to the use of products outside that asset allocation framework. But we believe that structured products can be a valuable tool for managers to enhance the return profile of their clients’ portfolios in a highly controlled, customised way. And the rise of technology means this can be achieved far more easily and quickly than ever before.
David Wood is managing director of international business at Luma Financial Technologies, a US-based provider of platform technology for financial professionals
