Proprietary indices in the US structured product market have had strong market share for many years. Two of the leading index sponsors of this period are JP Morgan (Efficiente Series) and Goldman Sachs (Momentum Builder). More recently JP Morgan has developed its Mozaic Index and it has now brought the Balanced Value Dividends Index to market as its latest concept. All these indices are rules based and are calculated by a separate group within the bank or by an outsourced index calculation agent. The governance of proprietary indices has been made a regulated and heavily controlled operation since the advent of the Benchmark Regulation which came in to force in 2018.
Capital protected solutions
Before analysing the properties and merits of these indices it is useful to step back and consider the wider context. The principal protected Certificates of Deposit (CD) sector remains very important in the US market. These appeal to lower risk investors who have typically come from fixed rate CDs which have offered extremely low rates for many years.
Distributors have sought to provide market linked alternatives and principal protected structured products are an obvious solution because of the necessary requirement deposits to be fully protected from any market losses. However the same headwinds that exist for fixed rate CDs come into play for structured products, very low interest rates and in recent years very low funding spreads from most top tier investment banks. Meanwhile volatility levels for most indices remain high, and the events of 2020 underline that trend.
Therefore the usual solutions for structured products such as a principal protected participation note to a mainstream index (such as the SPX-500 or Russell 2000) will not look attractive even if the maturity is pushed out to seven years or more. Many investors would accept a participation rate less than 100% but a participation rate of less than 50% (which is the range that these products would typically price) would never make it to market.
The sales environment in the US is dominated by group of distribution channels that have strong market share. They have the desire to offer a regular series of similar products, pointing to an opportunity to build brand, concept and familiarity.
Low volatility underlyings
Driven by these factors the market has turned to creating low volatility underlyings which will allow the regular products types (Participation notes and Auto-calls for example) to be feasible. Many of the leading solutions set a volatility target of 5% in order to allow 100% participation in some way to be achieved.
The first three of the indices mentioned earlier (Momentum Builder, Efficiente and Mozaic) employ similar concepts of a multi asset class investment which switches to follow the best performing sectors. This is then wrapped in volatility control mechanism. The idea is that in a reasonably strong market the allocation will be able to switch to equities and therefore capture as large a possible slice of any growth.
Appeal of proprietary indices
The creation and use of a proprietary index allows the investment bank to have a vehicle with which it can structure products on a regular basis. It also allows for two revenue streams: the fee to manage the index, and the profit booked for the structured product itself. This contrasts with using an external benchmark index where license fees would be payable instead.
It remains very challenging to provide true alpha or outperformance when constrained by a volatility limit of 5%. The Mozaic index returned 1.1% p.a. in the two year period of January 2018 to January 2020 and fell by over 7% in the first four months of 2020. By contrast the 5% volatility controlled version of the S&P-500 gained 5.5% p.a. over the same two year period and only fell by 3% up to the end of April. The asset allocation of these two solutions are different and clearly we would expect that there are market cycles that would favour Mozaic instead but this underlines the difficulty in achieving the performance needed to provide even modest returns that CD investors are looking for.
Keeping it transparent
Transparency is also a key consideration. None of the proprietary indices could realistically be called simple to understand. For an investor base used to fixed term deposits this is important to build trust and evidence outcomes that can be expected and understood.
Low volatility indices have been used in many markets over the years. The broad principle of the first generation of such indices is to take the allowed proportionate exposure into the underlying as dictated by the volatility limit. If your underlying asset has a current volatility of 10% and the target is 5% then 50% participation can be achieved. This participation will be regularly reviewed in light of increased or decreased volatility of the underlying asset.
A more recent methodology has been used in the latest JP Morgan index, the Balanced Value Dividends Index. This index ideally wants to track the leading ETF First Trust Value Line Dividend Index Fund which follows a strategy of investing in high dividend paying stocks with strong “safety” rankings as defined in a proprietary methodology. This ETF will be recognisable to many advisors and investors and has AUM of over $8 billion. Source for all indices and products referenced in this article is www.structruredretailproducts.com.
However its volatility is much too high to be usable directly within a structured deposit. The Balanced Value Dividends Index switches between the ETF and a lower risk asset, in this case a volatility controlled bond index aiming to keep to a 5% volatility target. By measuring ongoing volatility and correlations between the two assets, a calculation is made to determine the highest possible participation. This idea has been seen elsewhere in the market, for example through the S&P risk control 2.0 series, and minimum variance style portfolios that have been around for at least five years. They all rely on some mathematical alchemy to combine the original Markowitz portfolio ideas envisioned under simple assumptions of constant returns and volatility with the inherently unstable short term behaviour of different asset classes as measured by volatility and correlation. It will be some time before the market can judge whether such techniques add value or are lost in a combination of higher transaction costs and management fees.
As investor demand for principal protected solutions remains high, the desire to innovate and improve will always be a part of financial solutions in the market. These interesting solutions deserve consideration but this needs to be balanced against the benefits of simplicity and performance. As regulators like to say, a more complex solution should always be able to justify itself over a simpler alternative.