We have written extensively about the importance of asset managers’ ability to provide products that are unique and differentiated. This is likely to be especially true as we begin 2021, a year that will probably continue to be characterized by a high degree of uncertainty, which may weigh heavily on investors and their advisors.
Perhaps somewhat predictably, given the ups and downs of 2020, structured products are experiencing an uptick in popularity as investors grapple with the realities of:
- Near zero interest rates and anemic yields.
- Substantially higher and sustained volatility.
- An uncertain growth horizon with considerably lower return expectations.
Structured products seek to provide some level of principal or capital protection while at the same time offering upside return potential and/or providing investors a diversifying hedge. Traditional structured products, in their simplest form, are contracts in which an investment bank promises to pay the investor a return based on the performance of a second reference asset. The reference asset expresses the market view or outcome. It can be an equity security, a basket of securities, or an index, a proprietary index, interest rate bets, commodities, currencies, or baskets of each. In theory, at the end of the contract, the investor is returned their principal, along with a premium that is linked to the performance of the reference asset. These products, however, can be relatively expensive and opaque and therefore not necessarily suitable for many retail investors despite their many positive attributes.
Fortunately, the asset management industry has responded to the need for outcome-oriented solutions with ETFs that incorporate traditional structured product features. These ETFs are potentially disruptive in that they can package structured product-like characteristics at a lower overall price in a more transparent, liquid and tax-efficient ETF wrapper. Two popular features include offerings with a floor or a limit below which the product earnings are guaranteed not to fall, and a buffer that reduces the amount the client can lose by a set percentage.
As of June 2020, there were approximately 60 buffered ETFs with approximately $4 billion in AUM. Better than half of the assets—$2.3 billion—have been brought in during 2020. Buffered ETFs have been largely dominated by the first-to-market player Innovator Capital, which launched its original products in 2018 and have now rolled out nearly 50 buffered products. First Trust offered its first product in late 2019 and now has 16 different one-year offerings and held close to 30% of the ~$4 billion market at mid-year. 2020 saw two additional players enter the buffered space: Allianz, beginning in April, and TrueShares in July. As of the end of Q3 2020, that brings the total buffered ETF space close to 80 products across the four primary players, with assets growing close to $5 billion at the end of October, adding nearly $1 billion in Q3.
Unlike traditionally structured notes where repayment is linked to the creditworthiness of the issuer, the ETF investor’s ownership interest in the event of default is based on their proportionate interest in the underlying derivative contracts held by the ETF. In market downturns, this could be a meaningful distinction. Overall, the ETF wrapper provides a vehicle in which investment managers can structure differentiated product offerings, and we believe the demand for products with downside mitigation features will continue to create an opportunity for active managers to develop unique performance-driven strategies. Furthermore, risk mitigation strategies—like convexity—that can help portfolios on a risk-adjusted basis are likely to garner investor interest. For example, Simplify Asset Management has launched benchmark-driven ETFs that employ advanced options overlay strategies that are designed to be highly correlated with the benchmark but are expected to have a positive divergence during market extremes. These ETFs offer no hard downside protection but theoretically allow investors to hedge their bets with an options strategy similar to that deployed by several of the buffered ETF players.
Understanding these new and more complicated products is essential. As with any product innovation, there is the possibility that some of these structured investments and ETF offerings will experience difficulties, either in terms of performance, failed customer expectations, misunderstandings, or inappropriate use by brokers or advisors. For some investment managers, the potential reputational risk associated with these new “protection” type products may not fit their business plan. But for other active managers with a unique value proposition and a proven performance history, the rise in the number of investors looking to preserve existing wealth may present a timely opportunity—and an ETF wrapper may once again prove itself to be a nimble and useful vehicle.
Finally, although some uncertainty on the regulatory front is likely due to shifting politics, increased retail investor interest in less traditional markets—like structured products and other alternative assets—is set to continue. With growing virus cases and a new president, there are many questions as to how the pandemic and markets will shake out. However, one trend is fairly certain: investors were shaken in 2020 and will, in all likelihood, be looking to add certainty in an uncertain investment world. Active strategies that can help investors preserve the capital they have today, while still reaching for some moderate upside opportunity are probable winners.
As a leading provider in the ETF space, SS&C has a complete understanding of the entire ETF ecosystem gained through broad industry relationships developed over the last 25 years. SS&C provides a unique ETF service model on one integrated platform offering Portfolio Management Support, Fund Administration and Accounting, End-to-End Distribution, Compliance, and Series Trust solutions.
Written by Michael Andrews, CFA
Head of Investment Products Research & Consulting