Market timing with the Lookback

The lookback construction is one of the longest standing concepts in structured products. It has a rich history and is still in use in today’s markets many decades after it first appeared.

Derivatives and structured products first gained real traction in the 1980s and 1990s with the investment landscape was fundamentally different to what it is today. High interest rates and moderate volatility meant that it was possible to create growth products with full capital protection and high participation in the performance of an underlying asset. In many cases it was possible to provide participation rates well in excess of 100% because of the value generated by interest rates and dividend yields.

The lookback concept

Supported by academic theory and trading appetite the “lookback” option was created. This gave a payoff of the growth of an underlying but calculated on the maximum price observed during the product lifetime and not simply its final value as is used in European option-based payoffs.

Linking a product to the maximum underlying value will give an outcome at least as good as the final value and will protect the investor against market falls from any peak level reached. Accordingly, the embedded option is much more expensive and therefore the participation level that can be offered is reduced.

Investors understand the importance of market timing and there can be few fund managers that have not claimed to have chosen optimal times to buy or sell at various times in their careers. The lookback option provides an automatic way to achieve this. However, this obvious ploy inevitably makes the option much more expensive and so the lookback was rarely popular even when product terms could reasonably support them. Investors can be a demanding group and those same people that want to achieve market timing usually expect markets to increase more or less in a straight line. To those investors a lookback makes little sense and most would prefer the higher participation.

Practical solutions

Therefore for several reasons the lookback as it was originally devised has not been seen for a long time. However the structured products market is a rich toolbox of techniques and solutions, with every mechanism waiting for an opportune moment to be employed. In the place of the original lookback an alternative concept has been seen regularly in recent years.

The term lookback is now more commonly used to describe setting the Initial strike price at an advantageous level for the investor. The typical construction involves taking underlying levels regularly (perhaps weekly) over an initial period (for example three months). The strike is set at the lowest level of this set of readings. It is called a lookback or “best-entry” because at the end of the initial period the best level has been fixed for the investor from the set of dates, equating to timing purchase of the underlying at the lowest level. As with any other product feature that provides a benefit it will necessarily result in a reduction of yield or participation or benefit elsewhere. However, in this case the effect is not as significant as that of a full lookback. This is because the lookback period is generally quite short and if the index falls steadily during the initial period this mechanism effectively equates to a delayed start. The most favourable outcome for the investor is actually a sharp underlying fall and then recovery all within the initial period which is relatively unlikely.

Current examples

Since this feature does not cost too much it is seen fairly frequently with over 800 such products on the www structuredretailproducts.com database. The countries where it is most popular are Taiwan (with 250 products), Canada (102), Belgium (99) and France (63).

Some examples are BNP Paribas Autocall Advanced Privalto in France (daily lookback for first two months), Morgan Stanley Lookback Entry Participation Securities in USA (weekly lookback for first three months) and Goldman Sachs Callable lookback in Belgium (monthly lookback for the first four months).

It is interesting that product manufacturers choose to employ this product feature quite frequently. One of the main reasons is surely due to behavioural finance reasons. Investors feel they should be placing their money somewhere with good return prospects, however they are often also fearful of a bad outcome or setback particularly if this occurs early in in the investment period. The same sentiment holds for advisers acting on behalf of investors and wishing to avoid awkward questions if markets fall. The best entry mechanism helps allay such fears because if the underlying asset falls in the first few weeks then the strike level will be set at a lower level and the product would not post an immediate mark to market or intrinsic loss. In this regard it seems like an ideal solution, but while protection and risk reduction is important for an investment so is having clarity of goals and a well defined market view. For an investor overly fearful of an imminent market decline the obvious question is why not wait until this period has passed and then invest.

All types of lookback features offer a certain improvement or optionality over the simple equivalent but necessarily costs something because of that same advantage. The key question is therefore does any investor believe there is sufficient uncertainty that it is worth paying for the privilege.