How to capture growth in an autocallable world

illustration of money plant growing from the soil

Strategists are cautioning investors to look beyond autocallables and take advantage of low volatility to buy growth products. The banks have listened, engineering new solutions to capture upside. But will investors take the bait? Yakob Peterseil reports.

Strategists at investment banks across London have been reporting the same thing recently: an uncanny feeling of déjà vu. With volatility down and stocks up, a number of bankers are remarking that today's markets are in some ways beginning to look very similar to what they last saw in 2006 and 2007. The memory is bringing with it not a warm rush of nostalgia, but concern.

Pete Clarke, equity derivatives strategist at UBS in London, says the last time we had strong equity returns and lower implied volatility, with somewhat higher interest rates, was right before the financial crisis hit. "That would have been a good time for investors to focus more towards defensive participation structures," such as growth notes, says Clarke. Of course, you do not have to be a historian of the markets to know they did not.

"Unfortunately, investor interest remained very strongly focused on accessing yield via ever-more-aggressive autocallables," he says. And the concern is that they may be doing it again.

Deutsche Bank strategist Anthony Chambet also thinks growth notes are "clearly interesting" today, but along with Clarke, the London-based equity derivatives strategist recalls that as "volatility became extremely low across the board [in 2005–2006], you saw people shifting to more aggressive barrier levels - but there was no motivation to change to growth-type products."

The strategists are all wondering the same thing: why aren't retail investors positioning themselves to take advantage of growth? Volatility is low and bullishness in European stocks is high. Growth notes also offer terrific protection for those worried about risks such as China and Federal Reserve tapering.

One obvious drawback, as Clarke points out, is that low interest rates have traditionally dampened product terms, but investment banks now have clever strategies to get around this problem.

The strategies have combined to deliver headline terms that don't look too shabby. Derek Westpfel, a key relationship manager at Meteor Asset Management in London, recalls that as recently as November, Meteor was offering a product that paid three times the upside of an underlying index with barrier protection and a 100% cap. "How much more attractive does it need to be?" he says.

In other words, there is no shortage of solutions for investors who want growth. But if it isn't a dearth of suitable products keeping them committed to autocallables, what is it?

The smart money is on growth

In October, autocallables commanded 66% of the UK market, up from 42% a year ago, according to Future Value Consultants. According to Westpfel, autocallables have been the most popular product in the industry for the last three to four years running. "Look at Meteor's product range. We've got eight products at the moment, and six of them are autocallables. That's just the market speaking."

"It's just a constant in this space that people prefer this kind of structure," Chambet concurs. The typical autocallable is a short- or long-term product that pays a fixed coupon as long as a barrier is surpassed. In certain circumstances, when the performance of the underlying surpasses a slightly higher barrier, the product will ‘call', or mature early, and return investors their money. That a product will call at the earliest opportunity has historically been the most likely outcome, according to market participants, effectively rendering autocallables short-term products. Capital protection permits the level of the underlying to fall by, say, 40% before the investor loses any money on the product.

But market participants argue that investors should be taking advantage of low volatility and equity prices to buy long-dated participation notes instead. The autocallable is by no means a bad product, but it is the wrong one for this moment, they say.

Both Clarke and Chambet in separate conversations describe a strategy that shows that the so-called smart money is very much behind them In 2013, institutional investors en masse started putting their money into long-dated call options on stock indexes such as the S&P 500 or the Hang Seng - similar to the way an ordinary investor might buy a growth note on those indexes. Clarke describes the optics behind the trade: "Back in April, you had a 10-year forward level on the Euro Stoxx 50 that was trading at close to a 20% discount to spot, because implied dividend yields were quite high and interest rates were at their rock-bottom. At that time, you could buy a 10-year at-the-money call option for less than 18%. In less than a year, we've seen the value of those 10-year calls double."

The prices of those options have risen since April, but Clarke maintains the trade still has legs. "If you can be paying 20-25% for a call that gives you at-the-money participation on an asset class that roughly doubles every 10 years, the risk-reward can look very interesting. Investors tend to find it hard to justify spending more than 20%+ on an option, but as vols get to ever lower levels it's really just an alternative way of gaining equity market exposure - with a more attractive risk-reward profile and a very low cost of holding in the early years."

It's not so simple to implement the strategy in a structured product, however. The reason is that low interest rates are not giving investors a huge amount of discount on the zero-coupon bond that is the backbone of the product. With less of a discount, banks have less money to buy the options that grant investors favourable participation rates. One route, the strategists note, is to pay a premium for the notes - say, 102% or 103% of face value - but advisers are divided about whether ordinary investors are willing to go that far.

Deutsche Bank and Société Générale are just two of the banks to have listened to these concerns and answered with products that Meteor's Westpfel might consider "attractive", but even the banks admit that these have had far more traction with private banking than with retail.

Strategies for trumping low interest rates

Hichem Souli, head of cross-asset pricing at Société Générale, spends a lot of his time thinking about how to get better participation rates in growth notes. A good place to start, he says, is with indexes that have high dividend yields. Benchmarks such as the Stoxx Global Select Dividend 100 will carry cheaper options due to lower forward levels, and are a handy way to get superior participation. Alternatively, investors can buy notes linked to proprietary indexes such as SG's that feature an embedded buy-write strategy, which will also cheapen the options.

Deutsche Bank trumpets growth products linked to vol-targeted indexes, which have ridden the fad for ‘risk-factor' investing onto many investors' radars. Investec has joined in with products linked to its Even 30 index [equity index; volatility driven; equally weighted; no dividends and no fees or charges]. Options on vol-targeted indexes are cheaper, and it's not hard to see why. Options are priced in part based on volatility, so controls that limit it would logically slash the price. Another trick is to find more funding, or money to spend. SG can "repack" a growth note - essentially shift the counterparty risk to another corporate name - and if the alternative name has a wider credit spread than SG, the bank will have more money to buy the derivatives, says Souli.

At the top end of the scale are so-called hybrid products that are designed to pay out the maximum of an index performance or a fixed coupon. This has a cost, of course, and it will lower the product's coupon, but if the underlying rises to a level that is higher than the fixed coupon, the product will pay out that growth. "If you believe in growth, this payout is definitely worthwhile doing, even if it is a bit of a lower coupon," insists Akilesh Eswaran, London-based head of index structured product trading at Deutsche.

The perennial appeal of the autocallable

In January, BNP Paribas carried the hybrid concept into retail. Partnering with StartPoint Investments, the UK arm of provider SIP Nordic, the bank introduced a kick-out supertracker product that pays out the maximum of the performance of the FTSE 100 index or a 21% coupon. It is ostensibly a six-year product, but can mature after just three. While it's too early to tell what sort of success the structure will have, its reception may hint at whether traditional growth products will ever take hold among retail investors.

Westpfel says the kick-out supertracker has its merits, but hedges a little when pressed. "Where I think it might suffer is: ‘What is it?' I was speaking with an independent financial adviser (IFA) about this very product, and he said, ‘It's got to be either one or the other - either a growth note or an autocallable.' If you try to be all things to all men, you'll fall down somewhere."

The quandary banks and product providers face, in this and other instances, is that investors just seem to like their autocallables. It is a happy quandary, to be sure, highlighting the fact that with the perennially popular product, banks met a real and lasting demand.

"Human nature is that you want it, and you want it now," says Westpfel. "Remember that for autocallables, the single most likely outcome based on past performance is that they will call at their earliest opportunity."

Dan Scharlach, who advises mid- to high-net-worth individuals at Innovative Wealth Partners in Indiana, says the biggest concern from customers when he tries to sell them on growth notes is reluctance to commit to terms of four, five or six years.

Along with what is in practice usually a short wait until maturity, investors are understandably drawn to the headline rates of autocallables, say others. "For someone in retail, the low-risk alternative is the rate you get on a deposit," says Deutsche's Eswaran. An autocallable picked at random, such as a recent one from Meteor, promises a double-digit coupon if the FTSE 100 and the S&P 500 finish at or above their initial levels.

"They're simple and they're clear," says Westpfel. "They're simple to understand and explain if you're an adviser and they're simple to live with if you're a consumer."

But the industry needs to make sure it is providing the best solutions, not just the most popular ones. That means educating investors - and IFAs - about what is out there, including growth products.

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