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Bullish or Bearish or just not sure?

By Gary Dale, Head of Intermediary Sales at Investec

Over the last 7 years or so, and on top of the usual equity highs and lows, investment markets have faced some sizeable challenges. The fall-out from Lehmans, the resulting credit and liquidity crisis, the banking crisis, fear of a triple dip recession and now the continuing uncertainties surrounding the equity and bond markets as global economies recover. Other than the general acceptance that, if looking for returns in excess of the risk free rate, being invested in the markets is better than not being invested in the markets, is there ever a right time for the retail investor to get into the equity markets?

Is now the time for retail investors to get into equity markets?

Many in the investment industry are forecasting that the next 5 years may indeed be similar to the last in terms of volatility. There are 2 key themes that can be taken from the table below. The FTSE 100 is widely recognised as the proxy benchmark for most asset managers and, with global equity market correlation figures where they are, broadly an indicative measure of most of the major world equity index movements. In all but the last 2 years, the average volatility is higher than the long run average volatility in the FTSE 100 which is around 15 (based on average of rolling 30 day volatility).

The second is that there would appear to be a tenuous correlation at best between returns and volatility so, without the benefit of hindsight, where does today’s investor find value with palatable risk? Beating cash deposit rates whilst being mindful of the threat of inflation is no longer as simple as investing for the medium to long term in equity markets.

Lastly, and with regards to interest rates, the 5 year swap rate (a typical measure used by providers of Structured Investments but a good proxy for interest rates in general) has fallen from an average of 5.68% in 2007 to 2.12% currently, a drop in excess of 60% over that period with no immediate signs of large improvements on the horizon; at least passed on to savers anyway.

Structuring products to fit the different investment market cycles

The Structured Investment industry is often hailed as one in which retail investors have a more alternative route to market in terms of underlying and the variety of pay-offs available. However comments such as "they're ideal when volatility is high", "when markets are low geared products have their place" or "kick-out plans are less attractive when markets are toppy" are consistently thrown around by many familiar with investment markets. But, in truth, the flexibility afforded by these gems of the investment world means that they literally can be structured to suit not only many different individual risk appetites but also many different investment market cycles. Perhaps this is an opportune time for investors to gain exposure to equity markets in such a way that removes the ‘market timing’ element from the decision making process?

Defensively delivering a return in a flat or falling market

Structured Investments with defensive pay-offs are not a new phenomenon but, in the current climate, are certainly proving popular with many different types available from a variety of providers. A defensive pay-off does not necessarily imply a market fall. Clients are looking to preserve wealth, however may want to remain exposed to equity markets without the associated risks. Structured Investments can work exceptionally well in sideways or to a point, falling markets which is a strategy rarely employed by traditional investments. Delivering positive returns when equity markets are flat or falling holds an obvious attraction in today's market.

For example, a product linked to the FTSE 100 offering a potential fixed return of 45%, provided the index finished no lower than 90% of its starting level, over a 5 year period, with full capital returned provided the FTSE 100 does not fall by more than half over the period does not seem particularly defensive. But a sideways market is akin to a defensive strategy. There is of course counterparty risk to consider. Delivering a pre-defined return over say a 5 year period when allowing for a fall in equity markets is a valuable proposition that many investors would be interested in.

On the pay-off part of the structure it is also possible to build investments that offer positive returns irrespective of market direction. Kick-out plans are offered where the kick-out feature is triggered when the underlying index on any observation point is below its starting level. There are also examples where, on maturity, the index can be lower than its starting level to generate competitive positive returns. This said, the pay-off profile is of course only one part of the "defensive" equation. Other variables such as term, optionality (American/European barriers), underlying asset exposure and collateralised counterparty exposure can all be tailored to deliver defensive products that aim to mitigate and reduce a whole variety of different risks. The adviser’s job is simply to piece them all together in line with the clients overall appetite for risk. The more defensive the strategy, the more expensive the structure but finding the balance is definitely achievable.

Balancing a clients’ portfolio

It would seem to be counter intuitive to invest in a product that pays out when equity markets fall however there are some very strong reasons for doing so, not least that many portfolios may in fact benefit from an element of "defence" when it comes to equity market exposure. The fear of volatility is now almost equal to the fear of "missing the market". Clients are also worried over market direction. Short term market predictions have always been futile however, with even longer term predictions, many experts are less certain on the course being set for equity markets. Given the last 2 points, many clients are still invested in long equity, so what strategy for them? In simple terms, investing in a product offering a pre-defined return for a fall in the markets held long would seem to offer specific benefit, so perhaps a natural hedging strategy could be considered? It is of course trite to state that to benefit from market upswings one must be invested in the market but, nonetheless it is true. The problem of course with this particular strategy as already highlighted is the associated volatility.

In summary products offering positive returns even when, to a certain extent, markets fall would seem to offer attractive benefits, and more so in the current climate of sideways movements. Being able to benefit from market downswings as well as up is clearly of potential benefit to many investors. Certainly in the short to medium term it would appear that equity market growth will be fractious, with market falls not uncommon therefore, whilst available, these "defensive" strategies should really be considered to let clients benefit from equity-linked returns, without trying to second guess the market.

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