The UK structured product market has been staunchly loyal to the FTSE-100 as its most common underlying for many years. Many markets around the world also stick to benchmark indices recognisable to their investors. In the US market, the S&P-500 is the most popular index but the Russell 2000 and Nasdaq 100 have significant usage to represent mid caps and tech stocks respectively. In Europe, markets used to divide along country lines with the DAX in Germany and CAC in France but following the advent of the Euro over twenty years ago the Euro Stoxx and other pan European indices have steadily established a dominant position. The Euro Stoxx 50 represents the largest multinational stocks and the Euro 600 has greater diversification.
There are two observations that can be made of the UK retail structured product market.
The position of the FTSE-100
The first is that the use of the domestic indices is very strong. While UK structured products have also embraced other indices such as the S&P-500 and Euro Stoxx 50 this is generally as a worst-of product type to boost yield rather than to achieve diversification.
The second observation is that until the last few years UK equity underlying choices were almost universally the FTSE-100. A few products have always been linked to UK stock baskets but these are fundamentally different propositions. The FTSE-100 Is extremely well known to investors and this is the main reason for its popularity coupled with the fact that UK structured product investors tend to be quite conservative and low risk so that standard and simple product types linked to the FTSE-100 have been the obvious choice. While the FTSE Allshare for example is well known in the funds world it has never been a viable alternative because of the lack of liquidity in options and futures and difficulty in hedging the smaller stocks.
Other FTSE indices
In the last few years there has been a significant increase in the use of UK index alternatives. These include the FTSE 100 Equal Weight Fixed Dividend Custom Index, FTSE Custom 100 Synthetic 3.5% Dividend Index (CSDI), FTSE 150 Equally Weighted Discounted Return Custom Index, FTSE UK Yield Weighted Price Return Index, FTSE4GOOD UK 50 Index and MSCI United Kingdom Sustainable Select 50 3.5% Decrement Index.
|Year ||2018 ||2019 ||2020 ||2021 |
|Percentage of UK only indices ||68% ||81.6% ||84.2% ||88.6% |
|Percentage of FTSE-100 alternatives ||7% ||8.6% ||13.9% ||22.5% |
Table of use of UK indices within UK structured product market 2018-2021
This table shows that products linked to UK indices only has increased over the last few years, mostly due to the drop in popularity of worst of FTSE 100 and EuroStoxx 50 based products which for this purpose we classify as non-UK. In 2018 they accounted for over 18% of products. It is noticeable that the use of alternatives to the FTSE 100 have grown significantly in the last two years and now stands at well over 20%.
These variations generally have fixed dividends (defined by yield or dividend points). The CSDI has a 3.5% yield whereas most of the others have a higher rate at 5% or equivalent. Fixed dividend indices have attracted a lot of attention in recent years across many markets as a more efficient way of banks hedging dividend risk. They all reinvest the actual dividend yield to create a total return version of the index and then deduct a predefined synthetic dividend instead. This means that banks are not exposed to dividend changes as part of their hedging which proved very costly in 2020 as we described in a recent article on hedging structured products.
Since these indices are all related to the FTSE-100 it makes hedging products a little easier since the liquid exchange and broker market in the FTSE-100 will help manage most of the volatility risk. As these indices gain further traction we can expect increased activity in their own options.
Such a construction can change an index return quite significantly and generally allows for better headline product terms. The key question will be does this extra yield or return compensate for increased risk and the possibility of underperformance compared to the mainstream version.
Some indices are also starting to use alternative and more efficient methodologies such as the use of liquid futures rather than actual stock levels to reduce hedging risk and transaction costs.
There has been significant development in indices in recent years and many indices are now specifically created to act as underlyings for structured products. Time will tell if long term performance and investor satisfaction are where they should be.
There is certainly a significant amount of education needed to explain the differences between these indices and the more well-known FTSE-100, particularly in a highly regulated market such as the UK. Given the tendency for the UK market to be quite conservative it is not surprising that moves away from the FTSE-100 have been into variations rather than brand new concepts. However these alternatives should not be thought of as identical to or clear improvements on the parent index. Inadequate or misleading governance would quickly run into problems from the UK regulator FCA for distributors and advisers.
So far there is has been little use of ESG compliant indices. FTSE itself launched its FTSE4GOOD index many years ago but so far it has had limited structured product take-up. This may increase in the future.
In summary we find that the previously conservative and narrow focused UK market is slowly opening up to alternative choices and this would be a welcome trend if supported by sound propositions and proper education.
A version of this article has also appeared on www.structuredretailproducts.com
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Towfiqu Barbhuiya / unsplash.com