Index or Basket?

Many retail structured products are linked to a single equity index for direct exposure to a country, region or sector. Products linked to a single mainstream index such as the Eurostoxx-50, S&P-500, Nasdaq-100, Nikkei 225 and FTSE-100 are extremely common around the world and in many cases they are the natural choice for an investor’s first or core structured product. Other indices such as the MSCI Emerging Markets Index make a good choice for diversification.

However sometimes a distributor might prefer to create and source a product linked to a custom created basket of stocks instead. Here we will examine the pros and cons of using an index versus a basket of stocks. Other ways to issue equity linked structured products are to choose a single stock for a targeted choice or to use mechanisms such as “worst-ofs” to generate extra yield through the higher premium of increased downside risk.

Advantages of an Index

Mainstream benchmark indices have built up familiarity and usage over many decades. They are known to most investors and therefore their usage immediately reduces compliance risks which is important in many markets. Mainstream indices are very well supported by active futures and options markets. Additionally, banks have become very experienced at direct hedging of an index by dealing directly in the underlying stocks when this is preferable. This liquidity around the hedging instruments is very important. It reduces hedging costs and facilitates the issuance of longer dated products. This creation of the fundamental building blocks of structured products is the main reason for using a liquid index.

With the advent of Exchange Traded Funds (ETFs) a wider range of indices have been successfully turned into low-cost liquid investments providing a wealth of choices for the more sophisticated investor. In recent years options and futures have also built up for some of the well-known Exchange traded funds (ETFs). ETFs are themselves traded versions of indices and can either act as a hedge or a direct alternative underlying.

Choosing a basket

However, the structured products market is not limited to index based solutions. The major benchmark indices are so well-known that it is easy to forget that they are a basket of stocks, subject to certain selection rules determined by capitalisation and sector with regular rebalancing to ensure that the choice of stocks continues to represent the index aims accurately. Therefore it is possible to alter an index definition to provide alternatives.

For a distributor to decide to create a custom basket instead of using an index requires them to have a clear choice of stocks in mind. The stocks might be particular growth stories, themed by sector or other property, or selected for pricing reasons (for example high dividend yield).

We would normally expect no more than ten stocks in a basket otherwise explaining the choice would get complicated to investors. Basket linked products are often relatively short dated because it is important that the choice of stocks remains relevant and compelling and because of the problems that are caused by corporate actions.

One of the main issues that basket products face is that of stock substitution when a corporate action occurs. Share splits and takeovers will require choosing another company to go into the basket. While this is normally straightforward, communicating this to investors can be tricky as well as managing the appropriate reporting administration. This is a distinct advantage of indices where it is the job of the index calculation agent to deal precisely with such occurrences and leave the investor with a single defined concept of the index timeseries.

The rise of the AMC

A more recent development of the use of baskets is that from the increasingly popular Actively Managed Certificates (AMC) sector. AMCs provide a low-cost way for fund managers to follow any strategy in a certificate wrapper. These allow fund managers to choose a portfolio of stocks and to rebalance them in order to reposition an investment as the fund manager view changes. AMCs can be offered as delta one investments or wrapped into a structured product if a suitable hedge provider can be found.

With increasing choice and customisation the traditional boundaries of index and stock baskets are blurred somewhat. Mainstream indices will always maintain a strong position as the choice for most retail investors. Beyond these an array of more thematic and specialist indices, custom baskets and the flexibility of the AMC framework allow distributors to create new product offerings where a sufficient case can be made to provide value and opportunity with a niche solution.