How to increase equity market exposure with guaranteed protection
I have been considering the rollercoaster ride that was 2020 for investors and reflected on some of the investment decisions we made during that period. One area of particular interest to me was our use of “structured equity” – using equity derivatives to generate investment return and manage risk. The uncertainty we experienced last year occurs perhaps once or twice in a lifetime, with a huge range of potential outcomes. Using structured equity in fiduciary clients’ growth portfolios gave us more confidence to allocate to return-seeking assets during the pandemic, increasing return potential for clients but with guaranteed downside protection if equity prices fell.
Structured equity in a nutshell
What is structured equity?
An investment in a portfolio of equity options traded with a bank, which allows the investor to tailor their exposure, to provide a contractually guaranteed payoff profile.
How do we access structured equity?
The key to being able to use these instruments is having access to the right structuring and trading expertise. Our in-house derivative structuring expertise allowed us to gain fast, low-cost and tailored exposure to equity markets, through use of equity options, and other derivatives.
When do we use structured equity as a fiduciary manager?
We use equity derivatives in our clients’ growth portfolios in 3 scenarios:
- Medium-term (6 months - 2 years) strategic allocation - the focus of this article, typically driven by a desire for enhanced risk-management within the portfolio
- Short-term (1 month – 6months) tactical allocation – typically driven by a desire to change the size and nature of the equity allocation over the short term, using derivatives as an efficient and cheap method of implementation
- Opportunistic allocation – typically driven by unusually attractive pricing for a particular structure, providing a compelling investment opportunity. My colleague James Faupel wrote a piece (“Stay alert – the power of the full investment tool kit”, August 2020) on such an opportunity, which came about from a spike in (market-implied) volatility last year.
Using structured equity to increase equity exposure in Q2 2020
Q1 2020 was a devastating quarter for investment return. In February and March 2020, at the start of the pandemic, we reacted decisively, selling equities and corporate bonds, and holding high levels of safe assets of cash and government bonds, thereby successfully protecting capital. Fast-forward a few weeks, and whilst the economic outlook remained extremely uncertain, the scale of the fiscal and monetary response from policy-makers was making their equivalent reaction to the 2008 crisis look tentative in comparison. This large backstop, in the form of immediate and very large fiscal stimulus, including furlough schemes, gave us the confidence to begin thinking about increasing our clients’ exposure to equities again.
However, we remained very concerned about the underlying economics. At that time, there was no clear path out of the crisis. There was hope, but no concrete evidence of the efficacy of the vaccines being produced. The longer the shutdown of the economy, the greater the irreversible damage to particular sectors, such as aviation, manufacturing, and those more exposed to global trade.
In May 2020, we made a decisive portfolio change. Our derivatives team implemented a 12-month structured equity trade for our fiduciary clients which accounted for 10% of their growth assets, a meaningful portion.
The basic idea of the trade was to provide the desired upside participation in equity market returns, but with a material amount of downside protection, to protect against a worsening in the COVID outlook.
Since implementation, we have had the positive reaction from equity markets that we were positioned for. At 13 January 2021, this “Call Spread” structure (shown below) had produced a return of 8.2% over c.8 months.
Source: River and Mercantile, 13 January 2021
What would have happened if we couldn’t use structured equity?
Had we been restricted to traditional assets, we would not have increased the equity exposure to anywhere near the same degree. The downside risks were too high for us to take that action with our clients' capital. Any increase in the allocation to equities would have been much more muted, most likely 2-3% at most, and therefore we would have given up on return potential.
Structured equity played a central role in portfolio construction during this unique crisis, allowing us to build growth portfolios for our clients that were robust to a range of potential outcomes. Banks and insurance companies have made use of these tools for decades, and we have been implementing these structures for our clients since 2005. In our view, this more “mechanical” defensive characteristic is key in arming us as a fiduciary manager with the tools we need to deliver on our clients’ desired outcomes.
If you'd like to hear more about structured equity, please get in touch.
This article constitutes a financial promotion and has been issued and approved by River and Mercantile Solutions, a division of River and Mercantile Investments Limited which is authorised and regulated in the United Kingdom by the Financial Conduct Authority and is a subsidiary of River and Mercantile Group Plc (registered in England and Wales No. 04035248).
Please note that this communication is directed at, and intended for, the consideration of Professional clients. Retail clients must not place any reliance upon the contents.
The value of investments and any income generated may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. Past performance is not a guide to future performance. Changes in exchange rates may have an adverse effect on the value, price or income of investments.
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