Individual structured products (known as notes or CDs in the US, plans and deposits in the UK and certificates in much of Europe) continue to be popular with increased sales volumes and issuance numbers year on year.

There are many reasons for this popularity, including a desire to manage risk, the appeal of defined returns such as yield or growth targets, strong risk-adjusted performance and an emphasis on volatility reduction and capital protection.

Tailored portfolios and reinvestment decisions

Many investors and the advisers who assist them prefer a portfolio tailored to match their risk tolerance, horizon and asset allocation targets. By buying individual products, investors can maintain direct control over a portfolio aligned with their financial planning or portfolio management goals.

When a product matures, it is natural for an investor to consider whether the performance (absolute, risk-adjusted or compared to a benchmark) has been satisfactory. They can then decide whether to allocate more of their portfolio and wealth to a new structured product and if so whether to re-invest back into the same product profile and underlying asset, make a different choice or move away from structured products altogether.

Improvements in technology and processes have made the issuance of products in smaller volume viable, so that issuers have very low minimum issue sizes. This allows for more tactical issuance and greater variety. In some markets, the most significant obstacle to increased issuance is making sure regulatory requirements are satisfied at point of sale.

However, despite the fact that there is an abundance of individual structured products available, some advisors and investors prefer the concept of a “collective” vehicle, such as a fund, model portfolio, or separately managed account (SMA). These have been around in different forms for many years but have been gaining traction recently, with the US SMA sector demonstrating strong growth and momentum. SMAs allow a fund manager to a portfolio of structured notes and other investments, offering investors a diversified portfolio across risk, underlyings and issuers, following the mandate or stated strategy. When an investor accesses an SMA, the manager handles the main selection process, providing the investor with a portfolio that retains many of the protection and return characteristics of individual products, without the need for constantly buying and selling.

In the UK, this concept has been taken further, with many structured product funds proving popular. This is essentially the same idea, except that the investor owns a holding in the fund, rather than a proportion of the individual instruments as in the SMA. This fund wrapper has a greater regulatory burden but allows for a more formal approach with official NAVs published daily. The biggest providers in the UK include structured product specialists Atlantic House, Fortem and IDAD, as well as some newer entrants such as Alternatives experts Downing.

Structured ETFs: A new frontier

Interestingly, this fund mechanism has not been widely adopted under 1940 Act fund rules in the US. However, the ETF sector has approached this concept from another direction.

The ETF market has exploded in the last twenty years or more, offering low-cost alternatives to mutual funds. Initially, ETFs were used as a cheaper and more liquid way to access mainstream indices such as the S&P-500. Over time, the choice of ETFs has expanded into the thousands accessing all kinds of indices. Alongside this growth, index expertise has developed many new techniques, such as factor investing and volatility control. The use of options in ETFs has been a significant part of this evolution.

There are many examples of “structured ETFs”, a term we can use to describe any ETFs that uses options or derivatives to shape the return (rather than just for leverage or to cover borrowing, which is more common but not always heavily promoted).

The classic “covered call and long put” strategies were among the first in the market and plenty of variations exist now. These include the First Trust / Vest ETFs, which offer various flavours of buffered ETFs, with different buffer levels and underlying indices. Some of these funds use a calendar laddering technique by continuously investing in twelve rolling monthly versions to reduce any short term market timing effects. Their stable includes the flagship “BUFR” ETF. Many of these buffered ETFs use the ETF on the base index, rather than the index itself.

Alternative providers with similar propositions include Innovator ETFs with their series of buffered and other defined outcome ETFs and TrueShares, with their Structured Outcome ETFs range.

Providers focusing on pure covered call strategy (selling options on an underlying asset you own to generate income) include JPMorgan with their Equity Premium Income ETF (JEPI), which claims to be the world’s largest active equity ETF. Investment management company Nationwide offers its leading Risk-Managed Income ETF (NUSI), which writes covered calls on a Nasdaq-100 portfolio with some embedded puts.

An interesting variation on the buffered strategy is the BlackSwan ETF (SWAN), which links to the S-Network BlackSwan Core Index to provide uncapped exposure to the S&P 500. This is achieved by allocating approximately 90% of the ETF to U.S. Treasury securities, with the remaining 10% to be invested in SPY options.

Quantitative house Quadratic has created the Interest Rate Volatility and Inflation Hedge ETF (IVOL). It is designed to hedge the risk of an increase in fixed income volatility and inflation expectations. It also aims to benefit from a steepening yield curve, a scenario historically associated with large equity market declines.

IVOL gains from interest rate volatility via its access to the OTC fixed income options market, making it a different proposition from simpler equity buffered strategies.

Both structured ETFs and structured product funds aim to provide risk reduction benefits for investors through a diversified approach. Their fundamental difference typically lies in the horizon of options employed. ETFs generally access liquid options with maturities of two years or less for direct tactical hedging. Structured products funds invest in longer-dated OTC products, usually of six years or more. These seek to benefit from the long term advantage in selling volatility and skew from taking controlled downside risk. ETFs are also starting to access OTC markets, with the Calamos Autocall ETF that has been announced being another example.

Both approaches are excellent alternatives for investors seeking to manage risk without building their own direct portfolios of structured products and providing different to achieve this goal.