Cloudy with a chance of good returns

When the stock market is soaring and all is well with the world, investing is relatively simple. You buy the market (before it soars) and sit on it.

But what if the stock market drifts sideways or drops sharply?

At Equilibrium, we believe our clients’ money should continue to work hard in these conditions too. One of the ways we can do this in portfolios is by using structured products.

‘Structured products’ is a City term that just describes a range of investments that can give the investor returns in different ways from usual.

Sunny days

At Equilibrium we invest primarily in ‘autocalls’.

Again, this is a bit of jargon, but an autocall is basically a contract between us and a bank. For example, if we agree to buy one today, then in a year’s time, if the market (such as the FTSE 100 Index) is higher – however marginal – the original investment amount is returned together with a payable coupon, say 10%, and the agreement ends. Happy days, especially if the market has returned less than 10% – we’ve beaten the market!

What if the market has fallen over the year? Well, all is not lost. The agreement rolls into the next year and in two years’ time, the same question will be asked: “Is the market higher?”. If it is, we get 2 x 10% = 20% plus our initial investment back and the contract ends.

Stormy days

What if it’s lower? Going back to our original question: “What if the market has a really bad time in the next 5 years?”

Well, there are 2 scenarios: – if the market has fallen by less than 40%, we will get all our original investment back. This is a pretty gloomy situation where the market has fallen by over a third for half a decade and yet a decent outcome for the investor who has not lost a penny.

What about the Doomsday scenario where the market has fallen by more than 40% over the 5 years?

In this case, the investor will lose the same in percentage terms, i.e. if the market is down 70%, the investor will only get 30% of their money back. This would be a very bleak outcome, but in the real world, this has never happened in recent history in the major markets we trade.

This is an important point. Whenever we look at investing in these products, we look to see what would have happened in the past. By analysing this on a daily basis, going back half a century gives us some idea of the risks and an indication of the probabilities of outcomes going forward.

Lightning strikes

All things considered, these investments would seem to protect capital in very bad outcomes and provide a decent return when markets are going up. So, what are the main risks?

A couple of key risks…firstly, if the stock market does soar then the investor’s returns are capped, to just 10% in this example, and results in relative underperformance.

Secondly, the contract is with a bank and if the bank goes bust – which is rare but possible – then the investor may lose some or all of the capital. We manage this risk by monitoring the financial fitness of each of the banks we trade with and ensuring we use a spread of different banks with limits on how much we have with each.

All-weather

At Equilibrium, we use these structured products to provide solid returns for the portfolios in most prevailing market conditions.

As you can see from Chart one, this has produced good returns over most periods since we started using the products nearly a decade ago, even beating the returns on the FTSE 100 Index. They also have the added benefit of having no annual management charges, unlike most managed funds.

Of course, we hold active and index funds to generate great returns when markets are booming but when the clouds appear, these products can provide a degree of protection.

This article is intended as an information piece and should not be construed as advice.

This article was featured in the autumn 2024 edition of our financial planning and investment magazine, Equinox. To download your free copy, click here.