Keeping the Black Swan at Bay

Ian Lowes, Lowes Financial Management

The Lowes Financial Management Review of the Decade published earlier this year showed that the evolution of the structured product sector had seen three major changes:

1. Autocall contracts have grown to dominate the sector. In 2010, 116 capital-at-risk autocall contracts were issued, accounting for 42.65% of the market, whereas in 2019 there was 266 capital-at-risk autocall contracts issued, accounting for 78.7% of the market.

2. A move to longer maximum duration autocall contracts has repositioned market risk. Whilst the average actual duration of matured autocall contracts within the decade was 2.16 years, the average maximum investment term offered by new issue products has changed significantly. In 2010 just 1.72% of issued capital-at-risk autocall contracts offered maximum term of more than six years and this rocketed to 83.83% in 2019.

3. There has been a shift away from riskier American style (intra-term) capital protection barriers to simpler European style (end of term) barriers. In 2010 just 34.93% of issued capital-at-risk products utilised a European barrier, whereas by 2019 100% of issued capital-at-risk plans included this type of protection.

Whilst the sector has performed extremely well these three changes served to provide a degree of ‘Black Swan’ protection that may now prove to have been very timely. A ‘Black Swan’ is a metaphor that describes an unexpected event that has a major impact on the stock market. The expression stems from a time when black swans were considered not to exist, albeit they were subsequently discovered in Australia in 1697. Rather than the metaphor being resigned at that time, it adapted to the extent that it acknowledges that the unexpected, or ‘impossible’ can occur. This year we have witnessed a Black Swan event, the likes of which we haven’t seen in several generations.

The Covid correction may take some years to recover from and the introduction of longer, maximum duration autocalls, coupled with the phasing out of American barriers, will provide potentially significant comfort to autocall investors. Such investments, many of which now allow up to ten years for the market to recover, could ultimately become some of the best performing retail investments in the market – provided the market recovers in time. If the market does not recover, the European barriers could result in them returning capital at maturity, despite prolonged bear market conditions. A return of capital with no return is not ideal but it’s certainly more ideal than a loss.

To illustrate, the following chart plots the final positive maturity trigger point and capital protection barrier for every FTSE 100 linked, capital-at-risk, retail autocall plan in issue.

Those with a final maturity date prior to May 2025 had a maximum term of less than 7 years. Those maturing in the later years had longer terms, which could prove valuable in the event of a prolonged recovery. The longer the maximum term, the more autocall observation dates on which a positive maturity can occur and the later the final determination point. Of the 573 plans in question, all but two utilised European capital protection barriers. The benefit being that in relation to the capital element of the plan, the index is only measured at the end of term and then, only if an earlier maturity has not been triggered. Falls in the underlying due to out of the ordinary events such as the Covid correction have no bearing on the barrier, provided the index recovers to at least above the barrier, or better still, the maturity trigger point before the final maturity date.

As the sector continues to develop in a positive way for investors, our message remains the same – focus on the end result, and ignore the daily noise – something allowable through movement towards end of term barriers and extended maximum investment terms. Currently the FTSE 100 Index is above all of the relevant capital protection barriers, however if there was to be another market crushing event in the near future there’s still time for it to recover. Further an autocall maturing positively on its final, rather than early observation dates, against a market that has been depressed, could, because of the benefit of snowballing coupons, prove to be an exceptional investment for its time. Obviously, the same investments taken out today might not have the same duration and total return but the defined returns and contingent capital protection will still afford the same, if not better peace of mind.