Nev Godley of Morgan Stanley looks into why one variation ofcapped return products has become very popular with investor over recent years - autocalls.
In last month’s columnI discussed how capping returns via structured products can actually serve to benefit investors when markets are only performing modestly. This month I will explore that idea further, introducing one of the most widely used and arguably best performing payouts of recent years – the ‘autocall’ or ‘kick out’ product.
To recap, capping the returns available on a structured product gives investors more exposure to the underlying asset up to that capped level. For example, an uncapped product might offer 80 per cent of any FTSE 100 Index upside over a six-year term.
However, if the product only offers exposure to the first 50 per cent increase in the FTSE 100, the product might offer 120 per cent of that increase (resulting in a maximum return of 60 per cent, which is achieved if the FTSE increases by 50 per cent or more over the six-year term). The manufacturer constructs this payout by buying a ‘call spread’: buying one call option at a lower strike and selling another call option at a higher strike (that is, the cap).
Call spreads can either be very wide (where the cap is significantly higher than the lower strike), or very narrow (where the cap is only very slightly above the lower strike). The narrower the spread, the greater the premium the manufacturer will receive from selling the option with the higher strike. The narrowest call spread possible, where the strikes for the bought and sold option are pretty much identical, is often referred to as a ‘digital’ option. It is in fact one of the simplest option strategies to understand: if the underlying asset closes below the strike, there is no return. However, if the underlying asset closes above the strike, a fixed return is achieved.
Digitals would be most attractive to investors who have a neutral or only mildly bullish view on the underlying asset. They provide an opportunity for a fixed, attractive return if markets are flat. However, if markets appreciate more than expected, the fixed return that a digital offers may be less than investors would have achieved from investing in the underlying asset directly.
Digital options form the backbone of many different structured payouts, but one of the most common is the autocall. Autocalls, or ‘kick outs’ as they are known are structured products that mature automatically and pay a fixed return if certain conditions are met on pre-specified dates during the investment term.
They typically have a maximum term of six years and offer the chance for early maturity each year. If, on these pre-specified dates, the underlying asset is at or above a certain level (the ‘initial underlying level’ in the diagram), the product matures early and a fixed return is paid (the ‘Max. Return’ in the diagram).
This return usually grows each year until the product matures. For example, a product could offer 8 per cent if the conditions for the product to mature early are met after one year, 16 per cent if the conditions are met after two years, 24 per cent after three years, and so on. They are typically ‘structured capital at risk products’, which, if you recall from the feature I wrote in April , means that investors’ capital is at risk if there is no early maturity and the underlying asset falls by more than a pre-determined amount over the investment term.
An autocall is constructed by putting together a series of digital options, one expiring on each autocall date. These digital options are only activated if the product has not matured early on any of the earlier autocall dates. When an autocall date is reached, one of two following things will happen:
– If the underlying asset is above the pre-set barrier the digital Option will pay the fixed return and the autocall will mature early, repaying investors their initial investment, or
– If the underlying asset is below the pre-set barrier the digital Option will expire worthless and the autocall will continue to the next autocall date, when the next digital Option will activate.
Autocalls have been extremely popular with UK retail investors over recent years, as they have offered the potential for attractive, fixed returns in otherwise flat or lacklustre markets. They have also appealed to investors who are uncertain as to when equity market recovery might start: Investors do not need to take a specific view on market timing, they just need to believe that the underlying asset will be above a certain level on any one of the autocall dates to generate a return.
Similar to capped return products, autocalls are not for everyone. If your clients are strongly bullish on the underlying market, autocalls are probably not right for them as the digital option limits their returns to the fixed amount only.
Equally, while investors need to be prepared to keep their money invested for the full term, they will get their investment back if the product matures early on one of the autocall dates. For this reason, they should also have a flexible investment horizon. However, for investors who expect markets to be relatively flat and do notmind when their investment matures, autocalls could offer the potential for attractive returns.
Nev Godley is vice-president of Morgan Stanley